Fcdeial Deposit Insurance Coiporaiiun 

Gh airman 

WilliamTaylor 

Division of Research 

and Statistics, 

Director 

Wm. Roger Wa[son 

Editor 

George E. French 

lid itori al Com mi ttee 

Fredericks, Cams 

Gary S. Kissel 

Arthur J. Murton 

Adminis trati ve an ager 

Delia Voesar 

Editorial Secretary 

Cathy Wright 

Design and Production 

Graphic? and Distribution Unit 

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FDIC 

Banking 

Review Fall 1991 

Vol. 4, No. 2 

Table of Contents 

Early Corrective Action For Troubled Banks 

by George E. French page! 

Data pertinent to the operation of the supervisory system for U.S. commercial banks are presented 

in this paper. Supervisors generally identify banks' problems well in advance of failure, and 

influence banks' dividend payments and capital injections in the "correct" direction. The author 

concludes, however, that improvements are possible in forcing realistic loss recognition, limiting 

dividend payments and resolving troubled institutions earlier. 

Bank Dividend Patterns 

by David K. Home page 13 

Commercial bank dividends increased substantially during the 1980s, both in absolute dollars and 

as a proportion of earnings. The historical trend of dividend payments, and their distribution across 

the banking industry, are examined in this paper. number of factors appear to influence dividend 

distributions. The impact of these factors, with particular emphasis on equity capital, is analyzed 

using a statistical model. The effects of dividend restrictions are discussed also. 

A Framework For Analyzing Deposit Insurance Pricing 

by Christine E. Blair and Gary S. Fissel page 25 

The question of whether to revise the current system of flat-rate deposit insurance premiums in 

favor of a risk-based system is addressed. While there is general agreement that relating an insured 

bank's premium to the risk it poses to the insurance fund would be desirable, the information-in 

tensive nature of the intermediation process in which banks specialize makes risk measurement 

a difficult task. An overview of alternative methods for establishing risk-based premiums is 

presented, followed by a discussion of the arguments for and against risk-based premiums. 

Recent Developments Affecting Depository Institutions 

by Benjamin B. Christopher page 39 

This regular feature of the FDIC Banking Revtew con tains information on regulatory agency actions, 

state legislation and regulation, and articles and studies pertinent to banking and deposit insurance 
Early Corrective Action For Troubled Banks 

Early Corrective Action 

For Troubled Banks 

by George E. French^ 

In order for proposals to reduce 

deposit insurance costs through 

improved bank supervision to be 

effective, it is necessary that: 

i) supervisors identify banking 

problems early enough to be able to 

affect insurance costs; n) supervisors 

have the capability and willingness to 

affect bank behavior in ways that will 

reduce insurance costs; and iii) the 

current supervisory mechanism can 

be improved. This paper examines 

data pertinent to these questions and 

evaluates proposals to improve the 

supervisory process in light of the 

information presented. While there 

are aspects of bank supervision that 

can be improved, claims for massive 

and costless reductions in insurance 

costs through "early closure" appear 

overblown. Nevertheless, it is argued 

in this paper that an early-closure 

policy that allows for limited 

supervisory exceptions would 

represent an improvement over the 

current system. 

Events in the 1980s demonstrated 

the potential costs of deposit insur 

ance, as the insolvency of hundreds of 

savings and loan associations precipi 

tated the bankrupting of the Federal 

Savings and Loan Insurance Corpora 

tion, and the Federal Deposit Insur 

ance Corporation began incurring 

unprecedented losses. Many observ 

ers have attributed a large part of the 

blame for these losses to inadequate 

supervision. 

Recent deposit insurance reform 

proposals would reduce the discretion 

available to bank supervisors, in order 

to correct their supposed lack of will 

ingness to use their authority aggres 

sively. The proposals typically 

require earlier closure or other super 

visory sanctions; which sanctions to 

use would be based on a bank's capital 

ratio. 

The potential for bank supervision 

to play an important role in controlling 

deposit insurance costs should be 

evaluated in light of evidence on how 

supervisors have influenced bank be 

havior. This paper presents informa 

tion on the operation of the 

commercial bank supervisory system 

in terms of detection and disclosure of 

banking problems, influence over 

bank dividends and capital injections, 

and recovery rates of undercapitalized 

banks. Areas where the system could 

be improved are identified based on 

this information. 

Detection and Disclosure 

ofProblems 

This section presents evidence rel 

evant to two general questions. First, 

do bank supervisors do a good job of 

ensuring the integrity and accuracy of 

banks' financial statements? Second, 

are bank supervisors able to detect 

bank problems early enough to take 

actions that might reduce the proba 

bility of loss to the insurance funds? 

Accuracy of Financial 

Statements 

In terms of sheer man-hours, the 

mostimportantactivityof bank super 

visors is to examine banks. Among the 

most important goals of examinations 

are to detect banking practices that 

pose a high risk to the deposit insur 

ance funds, and to ensure that banks' 

financial statements fairly present 

their financial condition. A bank's un 

insured depositors, other general nondeposit creditors and current and 

potential equity holders have an inter 

est in obtaining accurate information 

about the financial condition of the 

bank. The deposit insurer and pri 

mary supervisory authority also have 

such an interest. Bank management 

or other bank insiders, however, may 

sometimes have an interest in paint 

ing an overly optimistic picture of a 

bank's financial condition. 

Incentives to overstate bank in 

come and net worth may arise from a 

desire to maintain low-cost deposits or 

other funding sources, to attract capi

Chief, Financial Markets Section, Division of Re 

search and Statistics, Federal Deposit Insurance Cor 

poration. This paper could not have been completed 

without the invaluable research assisianee of Kenneth 

Walsh. 

Early Corrective Action Kor Troubled Banks 

Table 2 

Bank-Failure Costs to the FDIC 

($ in Millions) 

This column gives the amount of the failed bank's assets purchased by the acquiring entity. 

1 As nf September 30, 1989. 

Includes only failures occurring prior ro September 30, 1989, 

* The Bowery Savings Bank, First National Bank Trust Co. (OK), BancTexas, Syracuse Savings Bank, First City Bancorporation, First Republic Bank, MCorp, Texas American Bancsharcs, and National Bancshares Corporation (TX). These banks were resolved during the period 1985 1990. 

In some of these transactions, assets can be put to the FDIC at the discretion of the acquirer, so the distinction between retained and acquired assets becomes loss meaningful. 

Note: Reprinted from Modernising thtFinancialSystem: RttommmdationsforSafer, MoreCompetitive Banks, U.S. Department of the Treasury, February 1991, following p. X-15. 

Source: FDIC. 

for loan and lease losses (ALLL) that 

is adequate to cover estimated future 

losses imbedded in the loan portib

lio.3 

Until year-end 1990, the ALLL 

was part of the bank's regulatory 

("primary") capital. A loss provision,11 

although a charge to net income, did 

not affect the bank's regulatory capi 

tal position and did not necessarily 

result in any adverse enforcement ac 

tion. Moreover, the nature of the ex 

amination process is such that banks 

that are targeted for examination tend 

to be in worse financial condition than 

those not examined, and are therefore 

more likely to have high loan-loss pro 

visions. The higher loss provisions by 

examined banks therefore are not 

necessarily the result of examiner 

banks in poor financial condition are 

examined more frequently. 

The operation of the bank finan 

cial reporting process and accompany 

ing supervision have attracted 

criticism. The General Accounting 

Office (GAO) recently has claimed 

that there are serious deficiencies in 

bank financial reporting. The GAO 

sampled 39 banks that failed in 1988 

and 1989 and found substantial over 

statement of asset values. 

As a result of the asset valuations 

FDIC prepared after these banks 

failed, loss reserves increased from 

$2.1 billion to $9.4 billion. A major 

portion of the $7.3 billion deteriora 

tion in asset values was not previously 

reported because deficiencies in 

GAAP allowed bank management to 

and mask the need for early regulatory 

intervention that could have mini 

mized losses co the Bank Insurance 

Fund.7 

There is little doubt that for finan 

cially troubled banks, loan losses 

For further informarion see Financial Accounting 

Standards Board statement No. 5, Atxoaaringfor Contin 

gencies, and American Institute of Certified Public Ac 

countants, Auditing lie Allowance for Credit Losses of 

Banks, 1986. 

A provision for loan losses is a "UpTM" iiem; the 

allowance for loan losses is the corresponding "stock." 

Thus, a loss provision is an addition to the bank's 

allowance, and a loan charge-off red uccaihc allowance. 

Under capital requirements effective January J, 

1991, the ALLL is not eligible for inclusion in Tier 1 

("core") capital. Loss provisions ihus will have the 

potential to bring a bank oui of compliance with capital 

standards, so that banks may become much more reluc 

tant ro add to the ALLL. 

U.S. General Accounting Office, Failed Bunts: 

Accounting nnd Auditing R/forms UigentJy Needed, April 

1991. 

pressure, but may reflect the fact that unduly delay the recognition of losses 71/iid. p.5. 
FD1C Banking Review 

often are far greater than are reported 

on financial statements. Data on the 

FDIC's costs of resolving bank fail 

ures from 1987 to 1989 are presented 

in Table 2. Depending on the type of 

transaction and the size of the bank, 

the FDIC's average costs have ranged 

from ten percent to 51 percent of 

failed-bank assets. 

It must be noted that some of the 

losses incurred in bank failures are 

incurred because of the failure itself 

and do not signify overly optimistic 

reported asset values. When an insti 

tution enters conservatorship or 

bridge bank status there may be dete 

rioration in franchise value as a result 

of the loss of low-cost core deposits 

and the departure of the best custom 

ers and personnel in search of more 

permanent relationships with other 

firms. Acquirers' bid proposals reflect 

the cost of asset reviews, transferring 

titles to assets, merging the failed in 

stitution into their own organization 

and, especially, for bearing risk. Fi 

nally, there may be a loss of efficiency 

resulting from government liquida 

tion of assets as opposed to privatesector liquidation. 

In short, there are good reasons to 

believe that the value of a bank as a 

going concern is greater than its liqui 

dation value. Unfortunately, there is 

no good measure of this difference, so 

it is difficult to tell how much of the 

shortfall between the book value of 

failed-bank equity and the FDIC's 

subsequent costs is due to this "liqui 

dation differential" and how much is 

due to overly optimistic reported asset 

values. To ascribe the FDIC's sub 

stantial failure-resolution costs en 

tirely to liquidation costs is 

implausible, however. It is more 

likely that in most failed-bank cases a 

substantial amount of loss was im 

bedded in the institution but not rec 

ognized on the financial statements. 

One could conclude that the super 

visory system has not been entirely 

effective in forcing loss recognition by 

troubled banks. As stated by the 

GAO, in part this is probably due to 

Table 3 

Reported Equity Capital for Failed Banks in 1989 

1982 (H2) -1988 (H2) 

Sourec: Board of Governors of the Federal Reserve System. Reprinted f rom Modernizing lie Finan 

cialSystem: RecommendationsforSafer, More Competitive Batiks, U.S. Department of the Trea 

sury, February 1991, following p. X-3. "HI" denotes June 30th Call Report data, and "HZ" 

denotes December 31st Call Report data. 

the leeway given to banks by GAAP, 

which allows them to establish loss 

reserves for problem assets based on 

the assumption that asset sales will 

occur under "norma! market condi 

tions" rather than current market con 

ditions. 

Early Identification of 

Problems 

Apart from the question whether 

supervisors have forced the account 

ing recognition of banking problems 

is the question whether they become 

aware of problems early enough to 

reduce expected costs to the insur 

ance fund. Data pertinent to the ques 

tion of how early problems are 

recognized by supervisors are pre 

sented in this section. 

Publicly reported financial data on 

banks that failed in 1989 are pre 

sented in Table 3. The data indicate 

that in the years prior to failure, the 

failed banks' reported equity capital 

ratios began to decline. The mean eq 

uity capital-to-assets ratio for the 

failed banks in the sample declined 

steadily from 10.1 percent in the sec 

ond half of 1984 to-1.1 percent in the 

second half of 1988, just prior to fail 

ure. Similarly, the percentage of the 

failed banks not meeting a 5.5 percent 

equity ratio increased from eight 

percent in the first half of 1985 to 94 

percent in the second half of 1988. In 

general, then, most of the failed banks 

in the sample were identifiable as un 

dercapitalized prior to their failure. 

Some of the failed banks, however, 

continued to report financial data that 

indicated that they were well-capital 

ized until relatively shortly before 

they failed. Thus, for example, 32 per 

cent of the banks that failed in 1989 

reported equity ratios exceeding 5.5 

percent as recently as the second half 

of 1987; six percent of the failed banks 

reported equity exceeding 5.5 per 

cent as recently as the second half of 

1988. It is very likely that many of 

these banks had incurred economic 

losses that were not reflected in their 

financial statements and that had not 

H The regulatory capital requirement for banks 

ill rough out much of rlie 1980s was-I.-1) percent primary 

capital and 6.0 percent total capital. These capital mea 

sures include loan-loss reserves, however, which are 

not included in equity capital. 
1 

Early Corrective Action For Trouhled Banks 

Table 4 

Examination Data for 347 Failing Banks 

1-1-89 through 9-30-901 

IndmlcsullmnimcrL-hii-jniJ BIF-insureJ savings banks failing between 1-1-89 and9-3(M)0. li;inks receiving assistance art not included. The figures in [life table include hoch 

CAMEL rulings assigned Through the examination process smd through cither means. 

Note: Reprinted UiimMaz/fnikiaglhe Fhiannal Syslem: Renmmeiulaliiimfor■ Safir, Mart Gtiapelilivt Hints, U.S. Department of the Treasury. February 1991, following p. X-3. 

Source: FD1C. 

been detected in the examination 

process. 

Supervisors' examination racings 

are a source of information about 

banks that is not publicly available. It 

will be useful to analyze how early the 

examination process identified banks 

that eventually failed as posing a 

threat to the Bank Insurance Fund 

(BIF). Examination data on the 347 

commercial banks and BIF-insured 

savings banks that failed between 

January 1, 1989 and September 30, 

1990 are presented in Table 4. The 

data tabulate the time prior to failure 

that banks were first identified as 

"problem banks." A "problem bank" 

is a bank that is assigned a CAMEL 

rating of "4" or "5" on a scale from one 

to five, with five being the worst. A 

CAMEL rating of "5" is intended to 

indicate a bank that has a high proba 

bility of failure within the next 12 

months, and a CAMEL rating of "4" 

is intended to indicate a bank that has 

problems which are sufficiently se 

vere that, if not corrected, the viability 

of the bank would be threatened. 

Table 4 indicates that 35 percent of 

these banks had been identified as 

problem banks more than three years 

prior to their failure, and 64 percent 

had been identified as problems more 

than two years prior to their failure. 

Only three banks were never identi 

fied as problem banks, and only 12 of 

the 347 were first identified within six 

months of their failure. 

All but seven of the 347 failed 

banks had received a CAMEL rating 

of "3" more than one year prior to 

their failure. Three-rated banks gen 

erally receive increased supervisory 

attention and frequently are subject 

to enforcement actions. Thus, prob 

lems at the failed banks generally did 

not go undetected even at those 

banks that were not officially desig 

nated as "problem banks." In this re 

gard, there are "good 3s" and "bad 3s" 

as reflected by the ratings assigned to 

the individual components of the 

CAMEL acronym. In addition, one 

must consider the possibility that the 

''3" rating was correct but that subse 

quently the bank developed prob 

lems that led to its failure. In general, 

however, the use of a "3" rating 

shortly before failure, as opposed to a 

"4" or "5," indicates that the exami 

nation process had not detected the 

severity of the problems. 

What are the implications of these 

figures for the ability of supervisors to 

take early steps to reduce potential 

insurance losses? Clearly, in most 

cases there was ampie lead time dur 

ing which the supervisors had been 

alerted that problems existed. By and 

large, supervision and/or the reported 

financial data appear capable of iden 

tifying banks that are potential losses 

to the insurance funds. 

It is also apparent that there are 

some cases in which problems go un 

detected, either in terms of reported 

capital levels, examination ratings, or 

both. Banks may fail to reserve ade 

quately for loan losses because of mis

guided optimism or deliberate 

misrepresentation, and this underreserving will result in overstated re 

ported capital levels. The examina 

tion process may fail to detect this 

misstatement of capital for two rea 

sons. First, some banks might not 

have been examined frequently. That 

is, the reason a bank is first identified 

as a "problem bank" less than six 

months prior to its failure might be 

that it had not been examined for 

some time. An alternative explanation 

is that some examinations may fail to 

detect problems. 

Table 5 presents information that 

is pertinent to this issue. The results 

of examinations that were performed 

at various times prior to failure are 

presented for the 347 banks that 

failed in 1989 and the first three 

months of 1990. For every time period 

considered, the majority of banks ex 

amined are identified as problems. In 

a few cases, however, the examina 

tions appear to have failed to identify 

problems. Thus, for the 347 banks 

that eventually failed, there were 165 

examinations conducted between 18 

and 24 months prior to failure. Thirtyfour of these examinations resulted in 

a CAMEL rating of "3" and six exam 

inations resulted in a rating of "2." 

Similarly, of the 197 examinations 

conducted between 12 and 18 months 

prior to failure, 17 resulted in ratings 

of "3" and six resulted in ratings of 

"2." 

CAMEL is an acronym For capiral, asset quality, 

managtmeni, earnings and liquidiry. Each ofihese five 

components is rated by the examiner and a composite 

raiing, the CAMEL raiing, is assigned. 
Tabls 1 

Ptatmmtron Daia for 347 railing Hank1, 

M-89 through 4-JO-901 

OAMUL UA'l I.Mj 

iiuiii Pninr [ih Failure ll 1 2 3 >'". (tfliKuinx 

I'.-,* rhiLii h rnnnrlin Z' n 0 L 0 SS .■0 

1 lo 11 jnnnthh ~\ n I n 20 

'■ 17 OS 110 

IH rn ?4 mnnihl II I. 

;■! rn "KJ rKjnfhx II I.I i;> 47 II 165 

JO lu ^b moiillih. II \l IE irv.i 

romrnfrcul iind DlP-insurcd divine tiin*' lul;: l<iwn I L mil' 

n^r:rnnrij ;,■ (.([ mr udr-1 D in.lud" lawiaxs, mi 

^- -In-1 

.- iiilcd Liuii 

lIiz I ni^ Y. hLhn-i, I Hil. :■}.■■. j-|i 

FDIC 

Thus- the:? ut u few 

a hunk Lfcac mi liinuphc :n pose 

1111111 l [lull 11 i r l -i 1 in llil 

Turned cnicia be u n&" is u 

rhc 

depch af problem;- ie nuM 

iIn k-" [.n^lhlc 'i hcfnmc1. rn 

ooin*if e H^^lu^.Thll Julbi 

ni ch^ icccinn, hawcvcj. 

J.-M rh.il in innM <■ ,'L', lliC » 

jf failed b^nki had been 

ea."i -m ior [£i lulure 

EffettQi Bonk 

Si i |i. iii'nmnllncii^c bink 

isr ini'ay, rhir^re difijtulr r.i i[n:n 

[l:y I'hcsc lli^Iuqc enc deicrcnte of 

Hfl'l iihil|l .1 Ij-ui^, J-Ld Lll^ CIl

of icnind -nikrwnrmg 

and. o^cratLr.c po-Lioiei 

Tb:re are urhej ubji.rv,i|ilL kind' n: 

bar.k ^c.ia^ ior ihaL on: oiiLd eiipetx 

b ir.k iuutn jfwrj iu ihIIn'mll. I^lkt

[lijCinn on rrnik div.dend 

4nil :.■ ![' 1.11 iii|tr Mini] i? 

Dividend Rest net ion* 

Dlicsi mi ,hv lIl nd iij.1 me mi by 

I .^ cnrrirriejcLa^ banlij fruni Iflfit

lmiiL^Li 1(390 jic pieicnie-d in Tible 

S. Seveniy-nnr jh-ccih nMI S ;om

IJivi.1l-n I |U.ni;n[i bv banki 

LlL.LilenJj 'ivL'j^rl Liclmc^ii 4'l pcr

zenr. and 2^6 |>iri.i-iir ^f mi min 

iji.t Ili14 iilii'iil (■ niiL liink

divLdcnds b^nl negative uci 

In apprc^acc dividend, paym 

iLH.e IlUC fLuH.HlilCH.-ll * rrim-ll J; 

Income I hiii, in 1'^fi bank nee inLUtne 'i MS lliurv 11 ism iJuuhik" Kg 

iLvidend paymena. whiLe in 

iIimiIltiiI- '*'Oil lmirO llun 

In geneiiil, ]hHth, uf 

paymenci appear cons^ce-iic tub :he 

|h.ll | k *ii[iflv''nnlinnl fllvi 

paid by weak bankfl. E 

it iin >• ni' <1 in "r^hlo 7 On 

banks wich ibe be;r ^ 

H .\MliL L I") paid 

mI■> il .11ivi ui ,11 

and banks wnh EUitcjuvely 

.- 1.1line' paid iitKci^ivcly \avtcs 

JtliUlvL lij :^1sl:.- Tln^ w 

cine in evejv vear from 1HH&4 

ihe Lnicraccion uf divulendj wiih 

;mhh iii?-, -nd facial 'cc Home 

do noc pro e- [hac ciie 

dividend naymen:^ ol weaker 

Lull k ^ «n£ I 111 lO^iijLl lif siiii^i vi 

influence jaiher ih^n bank 

Hnu'c-vcr, ai 

which Ln ihe 

j lu^h pLobrLiLLjiy oi laiLing 

w> vi 'i- ll i' liktls ill.11 lIil 

i n|.i n| vi, fyr 

co pay ouc a^ rnu^b 

l»mil.U-ni.]|i:dend: I: seems hif^jilv 

probable :hac ihe loi1 lt>cl' nl iIiki 

:end payments in nn»L*l< in bsicik? arc 

r.h. 111 n 11 jtsu.r uf jupcn'iior.1 pjc

jurc In £=neral. h^nk :u ic-v i mj-j ,i|j

pcar i n ho I (i n^ d lv Ld:nd pnymenti 

'hi [hi c-ili^r Jiund. ai rcponed b> 

GLlberc Q^],\ Horn: ll'l'lli, and. 

1 Dci'JiiniLnl of I In- Tr.h|>iij.' 

timejhaicDeei:pcrnii[c:d pay div 

idend-,, [n IMJoitx |il.,l4lM"ki 

i-j-Ii ecjuHv ranufl b;:nieen z:ro and 

chre; pejeeni, wirh an a^trijic t-\\nu 

finjiiiiMlftJAluf H.'ll [.i:r.Cni,paid 

amouncin^ co L(J ba^Li 

ot ai^;[i Morcovci, rhc IVca

il L'nrl |ii.ir I: i.n.r rlnil |Iil i.in'.]L..T

-apitaliied bankfl cbaipaid dividends 

cended in he much larnci ihan i he 

n in iroiiu-itiih/i,J Oiink> ill li JilI nur 

pav dividends .V-; ir.dicarcd i^ I ahlc 

'i, nl jIk Ifrfi h'rik^ ^ilh i miif. nil"'. 

bcHveen zero and :hree perce^.r ac 

ycsii-cnd IMQiljhc 1^2bank^ [hai did 

nol ^.i^ 11 ii I'll nd* h.i'l .n .1 vrrjigt ji". 

ufjl44 million, vbi.e :hc J4 banks 

iiji p^id di.id:ndi had an avcfjjj.t 

m/± iif 71 7 hiill LT'i Tin, piilirrn r" |jrs 

in e^eiy y:3i for wbith. daia we:= cmI

l.-i lid i, ily 11?^ 11^1) On. l .[jU 

may be ihai :ma I bank? rely 

feer.ii 

ir ijivi" '\ <- [ii I" r rni 1311 |i'I 

iiy io ch:r ihe excuse uf jupcrvi:urv 

ha■! rended in la^nL arpc 

|h: n.iyrni 11- ijf il viiLl iiiL* 

TIh-ti. ii ht;k ]|ij|ili^.il"'ii lor |-.-r 

niiirmpundejrspiializec banks ic pay 

i.l 1 vi 11' 11O5- If <i 11:11 k' 1 Ii.ii mil 111.1111 

caned enough cipir;! m r/.eci juper

rcjy.ciLii, n ii ditlkulc in 

['I'll I'L or -, 11 l -11011 Id 11'" .iI'Il- III 

Mke capiral oji of rbr bank. Fund* 

paid niii a dividends intieaie ibe 

hi IK '■ tft*\, dn.Lar-lm-dnljai, in Lhc 

fvent uf ii iVlIutc. Suiit <iteih, rlur 

undercap 1 i^llzed banks ahnuld be 

in iriiiii...] in |i.s rl 11 idcud' in 

mg e'eot. Thu. 

td It lIlccio! circuni

il.iiii l ^ in vhIiii Ii 1.1111,1 itl 11 :-111111 II d 

10 pay dividend? i 

FDIC Banking Review 

some banks' cost of capital may in 

crease, but this is an appropriate result 

of reducing the degree to which own 

ers can shift bank-failure costs to the 

FDIC. Similarly, while there may be 

legitimate concerns about the effect 

on Financial markets of defaults of 

holding company commercial paper, 

financial support of a holding com 

pany generally should be of less inter 

est to supervisors than maintaining 

capital adequacy in the insured bank. 

Capital Injections 

One of the most important func 

tions of bank supervisors is to monitor 

and enforce compliance with capital 

standards. In part, this involves the 

prevention of dividend payments and 

other capital distributions by under 

capitalized banks, as discussed in the 

previous section. In addition, one 

would expect supervisors to put 

greater pressure on undercapitalized 

banks to seek outside capital. Data 

presented in this section suggest that 

this pressure exists and has had an 

effect. 

Information on the sources of 

changes in banks' equity capital, for 

sach year from 1984 through 1990, is 

presented in Table 7. Capital injec 

tions increase equity, and dividend 

payments reduce it. Net income rep 

resents the effect of the bank's past 

investment decisions and cannot be 

influenced by today's supervisory 

pressure. Therefore, as emphasized 

by Dahl and Shrieves (1989), the gross 

change in bank capital from one pe 

riod to the next, which includes net 

income, can be a highly misleading 

indicator of the influence of supervi 

sors on bank capital. 

Table 7 indicates that bank super 

visors have influenced capital injec 

tions in the "correct" direction. In 

each year from 1984 through 1990, 

banks with the worst safety rating 

(CAMEL "5") had capital injections 

ranging between three and nine times 

larger than the safest banks (CAMEL 

"1"). Moreover, the size of the capital 

injection is a steadily increasing func 

tion of the CAMEL rating; succesTablc 7 

Capital Accounts for Commercial Banks by CAMEL Rating 

Note: All figure* except ihnsc Tot the number of banks are expressed as a percentage of assets, and arc simple 

averages of the percentages foe individual hanks. 

Capital injection represents the sum of capital scock transactions, capital contributed through mci^rs, and 

capital transaction,1; with patent holding companies. 

Dividends arc the sum of dividend payment? on common stock and preferred stockNet income reptesents net income as reported on rhe "Call Report" plus the change in net unrealized loss on 

ma rkm Ic eqi my sec iinti es. 

Source: FD1Q 
Early Corrective Action For Troubled Banks 

sively weaker banks have succes 

sively larger capital injections. 

Ic could be argued, as in Dietrich 

and James (1983), that the higher cap 

ital injections of weaker banks had 

noching to do with supervisory pres 

sure but were simply the result of op 

timizing choices by the banks and the 

equity markets. Such an argument is 

largely one of semantics and seems 

unconvincing. Troubled banks issu 

ing capital do so at significant dilution 

to existing shareholders and may face 

their wrath. Even if pressure to raise 

capital comes from the bank itself or 

from uninsured depositors or credi 

tors, this presumably reflects a desire 

to avoid closure or other sanctions. If 

so, the capital injection is arguably a 

result of the operation of the supervi 

sory system. 

The data presented in this section 

suggest that supervisors generally in 

fluence bank dividends and capital 

injections in a manner that reduces 

the expected cost to the insurance 

funds. Discussion of other aspects of 

bank behavior is beyond the scope of 

this paper. Gilbert (1991), for exam 

ple, reports instances of undercapital 

ized banks that were permitted to 

grow rapid ly, or had their highest lev 

els of loans to insiders, while under 

capitalized. Such instances, and those 

reported here and in Home (1991) of 

dividend payments by undercapital 

ized banks, serve to emphasize that 

bank supervision is not perfect. Pro 

posals to improve supervision are re 

viewed in the next section. 

"Early Corrective Action" 

Proposals to Strengthen 

Bank Supervision 

It frequently is argued that regula 

tors do not close banks soon enough. 

The substantial losses incurred by the 

FDIC on banks that had been report 

ing zero positive book capital prior to 

failure are taken as evidence that 

banks should be closed either while 

they still have positive book capital or 

when the "market value" of capital 

reaches zero. Earlier closure could re 

duce insurance costs in three ways. 

First, banks that fail would have more 

capital and more franchise value. Sec 

ond, because banks would be closed 

sooner the moral hazard inherent in 

the continued operation of an under 

capitalized bank would be curtailed to 

some extent. Finally, the prospect of 

earlier closure could induce bank 

owners to hold more capital and oper 

ate more prudently. 

The prospects for reducing insur 

ance costs through early closure or 

othersupervisory action depend upon 

a number of the factors discussed in 

this paper. prerequisite for reducing 

insurance costs through early correc 

tive action is, clearly, for supervisors 

to be able to detect bank problems 

early enough to affect expected fail 

ure costs. The data presented in this 

paper indicate that this prerequisite is 

met. Most bank failures were identi 

fied as problem banks between one 

year and three years prior to failure, 

and experienced depletion of re 

ported capital. Thus, there generally 

is ample lead time prior to failure 

when action can be attempted to re 

duce expected costs to the insurance 

funds. 

Another prerequisite for effective 

early corrective action is that supervi 

sors must be willing and able to influ 

ence bank behavior in ways that will 

reduce expected insurance costs. The 

data presented in this paper indicate 

that this prerequisite is satisfied, al 

though imperfectly, with respect to 

bank dividends and capital injections. 

Supervisors have restricted dividend 

payments by weak banks. In addition, 

weak banks tend to have larger injec 

tions of new capital than strong banks, 

probably in an attempt to avoid super 

visory sanctions and closure. 

Finally, proposals to improve su 

pervision assume that the current sys 

tem could be changed in a manner 

that would reduce insurance costs 

while preserving the financial-inter

mediation-role banks currently per 

form. If we take as given that the 

lending function of banks is not to be 

drastically reduced, the question is 

whether there are "early corrective 

actions" that can be taken to reduce 

insurance costs as compared with the 

current system. Some recent propos 

als to improve bank supervision are 

discussed in this section, namely 

mandatory supervisory sanctions 

based on capital "tripwires," and the 

related concepts of "market-value ac 

counting" and early closure. 

Capital Tripwires 

Under these proposals, banks 

with the highest reported capital ra 

tios would be allowed expanded affil 

iation authority and other perquisites, 

while banks with successively lower 

capital ratios would become subject to 

increasingly severe dividend and op 

erating restrictions. These proposals 

aim to reduce supervisory discretion, 

which is said to result in too much 

forbearance to troubled banks, 

Reported capital ratios are a highly 

imperfect measure of bank risk. Fig 

ure 1 presents data on the distribution 

of capital ratios for banks of each 

CAMEL rating. It is evident that 

there are numerous "well-capital 

ized" banks which are in fact "prob 

lem banks" (CAMEL "4" and "5"). 

The capital ratios prevailing in the 

banking industry are low enough that 

even the most well-capitalized banks 

can have their capital wiped out 

quickly through imprudent lending 

and investments. 

Given the record of bank supervi 

sors, there is room for reasonable peo 

ple to differ on the desirability of rules 

versus supervisory discretion. Much 

depends on the specific rules being 

considered. For example, a manda 

tory prohibition on dividends or rapid 

growth for an undercapitalized bank 

It has been argued by Diamond and Dybvig 

(1983) and others that the economic value created by 

banks and similar depository institutions is in interme 

diating between rhe needs of savers and other eco 

nomic agents for a highly liquid, dcmandable debt 

instrument and (he needs of borrowers to invest in 

longer-term, illiquid projects. This type of financial 

intermediary is intrinsically susceptible to deposit 

runs. Deposit insurance is a way to overcome the mar 

ker failure of bank runs. 

See Modernizing the Financial System; Recommen 

dationsfor Safer, Mart Competitive Banks, U.S. Depart 

ment of the Treasury, February 1991, pp. 37-41. 
FDIC Banking Review 

Figure 1 

Distribution of Capital/As set Ratios 

by Average CAMEL Rating 

Frequency 

3,000 Average CAMEL Rating 

1 in 2 *> 3 iii 4 :■: 5 

2,500 

2,000 

Capital Ratio 

might be expected to do little harm 

and may reduce expected insurance 

costs. In general, however, given the 

multidimensional nature of bank risk, 

an extensive and rigidly prescribed 

list of actions that must be taken 

based on one element of the bank's 

risk profile is probably undesirable. It 

should be noted that rigid rules could 

even have the perverse effect of mak 

ing it more difficult to impose sanc 

tions on banks which, although in 

technical compliance with capital re 

quirements, are in fact unsafe and un 

sound. Figure 1 indicates that there 

are many such banks. 

"Market- Value Accounting" 

It often is argued that banks should 

be closed when their market value 

reaches zero. Generally, such discus 

sions do not define the term "market 

value." This is difficult because many 

bank loans are highly illiquid, due to 

differences in information about the 

borrower between the bank and the 12

potential buyer of the loan. Presum 

ably, a market-value closure rule 

would require closing a bank if the 

estimated current liquidation value of 

its assets is less than the value of lia 

bilities. 

In view of the large observed dif 

ference between the book value of 

failed-bank assets and subsequent 

liquidation proceeds, a liquidationvalue closure rule would require the 

closure of many banks with substan 

tial book capital. If this closure rule 

worked as intended, the insurer 

would not bear most of the costs of 

bank failures. Instead, the dead 

weight costs of failures would be 

borne by the banking system and by 

society. If deadweight costs are sub 

stantial, the liquidation-value closure 

rule would, by definition, result in the 

closure of banks that are viable on a 

going-concern basis. Over time, pre 

sumably this would result in a drastic 

reduction in the lending function of 

banks, because of the potentially sub 

stantial penalties imposed by the in 

surer on the holding of portfolios of 

illiquid loans. 

discussion of the role of banks in 

the economy is beyond the scope of 

this paper. However, prior to im 

plementing a closure rule based on 

liquidation values it would be impor 

tant to consider this issue seriously. If 

banks create economic value by inter 

mediating between highly liquid de 

posits and productive but illiquid 

loans, as argued by Diamond and 

Dybvig (1983), then to the extent this 

function is inhibited there would be 

some loss of economic efficiency. 

Early Closure 

Earlier closure could reduce insur 

ance costs indirectly, by curtailing the 

moral hazard inherent in the contin 

ued operation of undercapitalized 

banks and inducing healthy banks to 

operate more prudently. In addition, 

it has been claimed that there would 

be substantial direct savings from 

closing banks when they still have 

capital. Most discussions of early clo 

sure, however, do not discuss the pos 

sibility that the direct savings may be 

insubstantial in many cases, or men 

tion the potential costs of an early-clo 

sure policy. 

Direct savings from early closure 

would be limited to the extent that 

losses in failed banks were locked in 

while the bank appeared well-capital 

ized. There may appear to be a grad 

ual deterioration of net worth, but in 

reality this may only reflect a gradual 

and belated recognition of the effects 

of past decisions. Most bank failures 

are caused by imprudent underwrit 

ing standards coupled with lack of di 

versification. Such banks are highly 

susceptible .to regional or industry 

wide economic shocks. There is likely 

to be very little direct savings associ 

ated with closing these banks earlier. 

Once the bad loans are made, the loss 

belongs to the insurer regardless of 

when the bank is closed. In cases like 

this, the direct savings from early clo 

sure will result primarily from the fact 

that a larger pool of uninsured depos 

itors and creditors are available to 

share the FDIC's losses. These sav 

ings typically are of second-order im 

portance compared to the direct loss 

on assets in the failed bank. 

Second, it is worth pointing out 

that implementing a "mandatory 

early-closure policy" might simply 

For publicly traded banks or bank holding com 

panies, the market value of the shares of a troubled 

firm may overstate economic net worth because of 

corporate limited liability. Because the value of shares 

cannot become negative, arbitrageurs may purchase 

fora positive price trie shares of a firm whose expected 

value is negative. 

10 
Early Corrective Action For Troubled Banks 

Table 8 

For purposes uf this analysis. Tier I capital iscnmmon stockholders'equity minus all intangibles except purchased mortgage-servicing rights, where those mortgage-servicing 

rights may not exceed 50 percent of Tier I capital-Assets were not risk-adjusted nil did not include intangible assets excluded From Tier 1. 

1 CAMEL raring of "4" or "5" as of October 7. 19^1. 

.Source: FUJC. 

cause the exercise of supervisory dis 

cretion to be pushed one seep farther 

back, to the examination process. 

Thus, if requiring a write-down or re 

serve for certain bank assets will push 

its book capital below the critical level 

that would force its reorganization, su 

pervisors are 1 ikely to take a very hard 

look at the advisability of requiring 

such write-downs. Alternatively, su 

pervisors simply might elect to post 

pone examining a particular bank. 

The result may be to reduce the in 

tegrity of banks' financial statements. 

Finally, there are considerable 

deadweight costs " associated with 

reorganizing or liquidating a bank. 

Any policy that results in the closure 

of banks that need not otherwise have 

been closed will be beneficial only if 

the savings associated with closing 

nonviable banks earlier exceeds the 

extra deadweight costs of closing via 

ble banks unnecessarily. Thus, the 

exercise of supervisory forbearance in 

the closure process may be the result 

not of kowtowing to the banking in 

dustry or other perverse regulatory in 

centives, but of a rational calculus of 

cost minimization. 

As discussed earlier, closure costs 

include the administrative cost to the 

FDIC of structuring transactions, 

costs to the acquirer of merging the 

troubled bank into its organization 

and, especially, costs acquirers must 

incur for asset reviews and the dis 

counts they will demand to buy assets 

of uncertain quality. It is sometimes 

argued that this last category of cost 

can be reduced sharply by providing 

the acquirer with ongoing protection 

against losses on acquired assets. Such 

arrangements have their own costs, 

however. There are costs associated 

with monitoring these agreements, 

and the loss protection given 

acquirers may limit their incentives to 

do a good job managing the acquired 

problem assets. Finally, FDIC re 

moval and liquidation of the problem 

assets would result in administrative 

costs and liquidation losses. 

Some perspective on the addi 

tional deadweight costs associated 

with an early-closure policy may be 

gained from Table 8. Tlie recovery 

rates for banks falling between zero 

and two percent Tier 1 capital at the 

end of 1985, 1986 and 1987 are pre 

sented. More recent data are not pre 

sented, based on an arbitrary 

judgment by this author that at least 

three full years of operation were nec 

essary to make a reliable judgment 

about the status of banks that had 

been undercapitalized. 

Consider a rule requiring the clo 

sure of any bank with less than two 

percent Tier 1 capital. Table 8 shows 

that most of the undercapitalized 

banks that would have had to be 

closed under this early-closure rule 

were in banks that had either failed or 

were on the "problem bank" list by 

mid-1991. A considerable portion of 

these assets were in problem banks. 

For example, of the $28 billion in as 

sets in solvent banks with less than 

two percent equity at year-end 1985, 

only $4.3 billion were in banks that 

subsequently failed or were assisted, 

but $16.5 billion were in problem 

banks at mid-1991. For banks that 

were undercapitalized at year-end 

1986, recovery rates were even lower: 

$36 billion out of $39 billion in assets 

of undercapitalized banks were in 

The term "deadweight cost1," is not restricted [0 

the technical sense of a wasting of society's economic 

resources, bin includes wealth transfers from the in 

surer to investors m Tailing banks or bank assets. 
FDIC Banking Review 

failed or problem banks by mid- closed or resolved in the normal Claims for massive and costless re 

1991.15 course of events, but in which excep ductions in insurance costs through 

This evidence suggests that, in tions can be made through explicit "early closure" appear overblown.

general, banks chat reach very low lev supervisory estimations of viability, Much of the loss in failed banks may

may strike the correct balance be be locked in prior to any observed els of book capital do not recover from 

tween rules and discretion. deterioration in capital. However, their difficulties. Therefore, the addi 

most banks that were undercapital tional deadweight costs of an early- Conclusions ized between 1985 and 1987 have not closure policy would not be expected Supervisors generally are able to recovered. This suggests that addi to be substantial. There may be some detect bank problems well in advance tional deadweight costs arising from cases, however, in which an undercap of failure. They appear able to affect needless bank closure are not an over italized bank is viable. Because these bank behavior by limiting dividend whelming argument against an early- banks are the exception, supervisors' payments and encouraging capital in closure policy. An early-closure policy failure to close or otherwise resolve an jections by undercapitalized banks. that allows for exceptions based on undercapitalized institution should Improvements appear possible in explicit supervisory findings of viabil be the exception as well. process in forcing realistic reported asset values ity may strike the right balance be which undercapitalized banks are and further limiting dividend pay tween rules and discretion, and would 

ments by undercapitalized institu likely lead to improved incentives to 

Gilber[.{1991) reports higher recovery rates for tions. ward prudent banking and lower de solvent but undercapitalized banks. The difference is 

attributable to our criterion that excludes problem posit insurance costs. 

banks from the Use of recovered banks. 

REFERENCES 

Dahl, Drew and Ronald E. Shrieves. "The Impact of Regulation on Bank Equity Infusions." 

Journal of Banking and Finance 14 (December 1990>:1209-28. 

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

Journal of Political Economy 9\ (June 1983):401-19. 

Dietrich, J. Kimball and Christopherjames. "Regulation and the Determination of Bank Capital 

Changes: A Note." The Journal of Financed, No. 5 (1983):1651-58. 

Gilbert, R. Alton. "Supervision of Undercapitalized Banks: Is There a Case for Change?" 

Federal Reserve Bank ofSt. Louis Review (May/June 1991):16-30. 

Home, David. "Bank Dividend Patterns." FDIC Banking Review A (Fall 1991): 13-24. 

U.S. Department of the Treasury. Interagency Study. Modernizing the Financial System: Recommendations 

for Safer, More Competitive Banks. Washington, DC: U.S. Department of the Treasury, 

February 1991. 

U.S. General Accounting Office. Failed Banks: Accounting and Auditing Reforms Urgently Needed. 

GAO/AFMD-91-43. 

12 

mercial banks. Industry aggregate net 

earnings rose steadily from $14.0 bil 

lion in 1980 to $18.1 billion in 1985, 

followed by a slight decrease to $17.5 

billion in 1986. Subsequently, bank 

earnings exhibited substantially more 

volatility. 

Dividend distributions increased 

each year from 1980 through 1986, 

both in absolute dollars and as a per 

centage of net earnings. In 1980, for 

example, banks distributed a total of 

$5.1 billion in dividends, or 36 percent 

of earnings. By 1986, dividends had 

risen to $9.2 billion and represented 

over 52 percent of income. Unlike 

earnings, however, dividends contin 

ued to increase steadily to reach $14.0 

billion, equivalent to 89 percent of 

aggregate earnings, in 1989. In 1990 

the dividend-earnings ratio fell for the 

first time in the decade (to 84 percent) 

as a consequence of a small decrease 

in dividends in conjunction with a 

moderate rise in income compared to 

the prior year. 

Aggregate dividends generally 

have not exceeded earnings (with the 

exception of 1987, when the largest 

banks contributed to provisions 

against loans co less-developed coun 

tries). Banks generally retained suffi 

cient earnings to contribute to higher 

capital levels. In fact, capital in 

creased from $107.6 billion in 1980 to 

$219.9 billion in 1990, while assets 

also increased during the period. Eq 

uity capital ratios (aggregate equity 

capital to total assets) are presented in 

Figure 2. Despite increasing divi 

dend-earnings ratios during the pe 

riod 1980 to 1990, equity capital ratios 

displayed a positive trend. Equity 

capital ratios fell only in two years: 

1987 and 1989. However, the capital 

ratio in 1990, almost 6.5 percent, was 

considerably higher than the 5.6 per 

cent capital ratio held by commercial 

banks in 1980. 

The trend in capital ratios 

illustrated in Figure 2 indicates that 

the commercial banking industry, as a 

whole, achieved a stronger capital 

base in recent years despite the volaFDIC Banking Review 

Figure 2 

Equity Capital Ratios: FDIC-Insured Commercial Banks 

1980-1990 Percent 

7 

6.5 

5.5 

Illllllllll 1980 1981 1982 1983 1984 

tility of earnings. However, the re 

ported capital ratios do not reflect 

banks' liabilities stemming from de 

pletion of the Bank Insurance Fund. 

It has been estimated that approxi 

mately $30 billion are required to re 

plenish the Fund, given the losses to 

date.1 If the 1990 industry capital of 

almost $220 billion were decremented 

for this implicit liability, the adjusted 

aggregate capital ratio would fall to 5.6 

percent, equivalent to the equity ratio 

value in 1980 and a substantial fall 

from the 1986 ratio of 6.2 percent. 

Capital is not adjusted in this manner 

because deposit insurance premiums 

are to be assessed against future earn 

ings in order to replenish the Fund. 

Moreover, reported capital ratios do 

not reflect off-balance-sheet assets. 

As off-balance-sheet activity has 

grown, the protection provided by re 

ported capital ratios has decreased. 

Risk-based capital standards are in 

tended to ensure that capital require 

ments cannot be subverted by moving 

bank assets off the balance sheets. 

The steady rise in dividend distri 

butions may reflect several factors. 

The returns from capital investments 

in banking have declined during the 

1980s. In 1980 the return on equity 

capital (net income as a percent of 

equity capital, denoted ROE) was ap 

1985 1986 1967 1988 1989 1990 

proximately 13 percent based on ag 

gregate annual statistics. The ROE 

had fallen to approximately ten per 

cent by 1986 and declined further to 

7.7 percent by 1990. The decline in 

ROE would be expected to provide a 

disincentive for banks to retain earn 

ings in order to finance additional in 

vestments. High dividends might also 

reflect an effort by banks to restrict 

the growth of capital relative to assets, 

thus shifting the increased risk of 

bank failure to cteditors and the 

FDIC. 

The aggregate statistics obscure 

substantial variations in both earnings 

and dividends at the individual bank 

level. Not all banks paying dividends, 

for example, are either profitable or 

adequately capitalized. Of the 12,338 

FDIC-insured commercial banks re 

porting at year-end 1990, 1,598 were 

unprofitable. Of these, 361 distrib 

uted some amount of cash dividends 

on common stock. Of the 10,740 com 

mercial banks reporting positive earn

ings, 21 percent paid no cash 

dividends, 69 percent paid dividends 

11f ihe desired level of reserves was $1.25 per S10C 

uf insured commercial bank deposits, for example, the 

target level of reserves would be just civet $5.1.1 billion 

rtn$2h650 billion of deposits. Given current reserves of 

[he Bank Insurance Fund. $4.5 billion, an additional 

$28.6 billion would be required under iliese assump 

tions. 

14 
Bank Dividend Patterns 

that were less than earnings, and 10 Table 1 

percent paid dividends that exceeded Bank Cash Dividends by Equity Capital Ratio 

earnings. 

Because particular interest is often 

accorded unprofitable banks that dis 

tribute dividends, a brief examination 

af the 361 banks in this category may 

be illustrative. As a group, these banks 

lost $3.3 billion in 1990, but paid out 

a total of $771 million as cash divi 

dends on common stock. The mean 

year-end equity capital ratio for these 

banks was 6.9 percent; this ratio 

ranged from -3.1 percent to 29.6 per 

cent. The mean level of assets for 

banks in this group totalled just under 

$1 billion. These numbers suggest, on 

average, thatequitycapital duringthe 

year for this group of banks was suffi 

cient to finance both losses and divi 

dends. However, a number of banks 

in this group exhibited capital ratios 

considerably below average; some 

were insolvent by year-end. Dividend 

distributions by unprofitable banks in 

J 990 were modest in comparison with 

the previous year. In 1989 a total of 

322 commercial banks paid $1.7 bil 

lion in dividends while sustaining 

losses of $6.7 billion. 

A high dividend-to-earnings ratio 

may not necessarily be a cause for 

concern. Earnings in recent years 

have exhibited considerable volatil 

ity. Regular dividends, in contrast, 

have been more stable. Managers may 

tend to set a relatively conservative 

level of dividends to avoid the need to 

rescind declared dividends. In a year 

of below-average earnings, such as 

1987, dividends will appear high rela 

tive to earnings as banks choose to 

maintain regular dividends. In a long

term perspective, in contrast, the 

same level of dividends may appear to 

be conservative. If sufficient retained 

earnings exist to finance dividends 

when earnings are poor, maintaining 

dividends will have a limited adverse 

impact on the bank's financial condi 

tion. Moreover, the ability to maintain 

dividends when earnings fall is a 

Lintner {195&) documems such dividend eon sid

rations for corporate management. 

• Compared to all banks in this capital group. 

*" Calculated only for banks paying dividends. 

major incentive for banks to retain 

earnings. 

A bank's equity capital may pro 

vide a better description of its finan 

cial condition and ability to sustain 

dividends than does current income. 

An adequately capitalized bank with 

poor earnings may finance dividend 

distributions by depleting its equity 

capital. An undercapitalized bank, in 

contrast, would be expected to under 

take efforts (including reducing or 

eliminating dividends) to boost capi 

tal. Thus, from a policy perspective, 

the variation of dividends with re 

spect to capital is of particular interest. 

A description of dividend behavior 

across different capitalization rates is 

provided below. 

Examination of 1990 data from the 

Reports of Condition and Income 

(Call Reports) reveals that of 36 com 

mercial banks which were reported to 

be insolvent at year-end, three paid 

dividends on common stock at some 

time during the year (see Table 1). 

Dividends for the three banks totalled 

approximately $1.2 million, despite 

total losses of $56.2 million for these 

same banks. Another 155 banks re 

ported positive equity capital ratios 

below three percent. Ten of these 

banks paid $43.9million in dividends 

while experiencing losses of $698.1 

million as a group. In comparison, ad 

equately-capitalized banks (the term 

is used here simply to denote equity 

capital of at least six percent of assets] 

were more likely to pay dividends, but 

their earnings exceeded total divi 

dends by a considerable margin. Of 

those adequately-capitalized banks 

which paid dividends, dividends 

amounted to 63 percent of earnings. 

The numbers in Table 1 

demonstrate that undercapitalized 

banks have been permitted to distrib 

ute dividends, in some cases even 

while sustaining losses. Under these 

conditions, capital erosion is acceler 

ated and the probability of subse 

quent bank failures increases. To the 

extent that excessive dividend distri 

butions result in additional bank fail 

ures, or higher losses for banks that are 

closed, additional failure-resolution 

costs are imposed on the FDIC. Bank 

dividends are restricted under some 

circumstances, although the data pre 

sented in Table 1 suggest that these 

restrictions do not appear to be com 

pletely effective in preventing divi 

dend distributions by banks that do 

not meet regulatory capital standards. 

Closer examination of the quar 

terly Call Report data for the under

15 
f'DIC Banking Review 

capitalized banks reveals that, in 

many cases, dividends were distrib 

uted earlier in the year when banks 

reported adequate amounts of capital. 

Generally, most of the total annual 

dividends were declared by the third 

quarter, and sometimes earlier. Many 

of these banks reported adequate eq 

uity capital in the first several quar 

ters, as recognition of losses was 

postponed until later in the year. On 

a quarterly basis, therefore, only a 

small number of undercapitalized 

banks appear to distribute dividends. 

However, major provisions for losses 

are likely to be anticipated to some 

degree by bank management. Bank 

management has flexibility over the 

timing of dividends and loss recogni 

tion. When dividends are desired, 

there is incentive to delay large in 

creases to reserves for nonperforming 

loans until the end of the year, which 

inflates the real equity value of the 

bank earlier in the year. Thus, while 

the use of annual data may tend to 

overstate the frequency with which 

undercapitalized banks pay quarterly 

dividends, analysis of dividends by 

quarter is likely to underestimate the 

propensity to distribute dividends by 

banks that are functionally undercap 

italized. 

The pattern of dividend distribu 

tions varies from year to year. Table 1 

includes data for 1989 and 1990.3The 

1990 data may be of particular interest 

to the extent that the earnings and 

dividends experienced in that year are 

similar to the levels attained in 1984

1986, a period of relative earnings sta 

bility. When earnings are temporarily 

depressed, as in 1987, dividend distri 

butions exhibit a very different pat 

tern. The numbers in Table 1 suggest 

that adequately-capitalized banks 

tend to pay higher dividends. These 

banks also are likely to be more prof 

itable, and higher earnings tend to be 

associated with larger dividends, 

other things equal. To investigate 

dividend payout patterns in more deDiiTii on dividend pjiymtniE by blinks ueros& dif 

ferent capital ratios arc provided for 1986-1989 in U.S. 

Department oflhc Treasury (1991), pp. XI2-X14. 

tail and to identify the separate im 

pacts of earnings and capital on divi 

dend distributions, a dividend model 

was estimated using a regression 

framework. The empirical dividend 

model is discussed in the next section. 

Bank Dividend Model 

The cross-tabulations presented in 

the prior section indicate a relation 

ship between earnings, capital, and 

cash dividends on common stock. 

However, to obtain more precise mea 

sures of the separate effects of these 

and other factors on commercial bank 

dividends, we estimated a dividend 

model using a multivariate regression 

technique. The advantage of this ap 

proach is that it permits measurement 

of the size of the impact of each indi

vid ual factor, holding constant the re

maining factors. Variables of 

particular interest thought to influ 

ence dividend distributions include 

earnings, equity capital, charter type, 

and bank holding company affiliation. 

brief explanation of the model spec 

ification is provided below, followed 

by a discussion of the results and an 

example to illustrate the impact of 

individual factors. 

The general form of the model can 

be specified as 

y< =p 

t=\ 

where y; denotes dividends/assets for 

bank i, xi denotes earnings/assets, and 

the other explanatory variables (xz 

X5) include equity capital/assets, na 

tional bank status, state member bank 

status, and bank holding company af 

filiation. The error term is denoted iu. 

A switching variable, d, is a dummy 

variable which takes a value of zero for 

banks with less than three percent 

equity capital and a value of one for 

the remaining banks with at least a 

three percent capital ratio. The earn 

ings coefficient for banks with at least 

three percent capital is therefore the 

sum of the coefficient for total earn 

ings plus the coefficient for the re 

stricted earnings term, calculated as 

(l + &)■ This specification permits a 

different earnings effect for banks 

that are undercapitalized versus the 

remaining banks, under the assump 

tion that a larger portion of earnings 

might be retained by undercapital 

ized banks to augment inadequate 

capital levels. 

The dependent variable in the 

model is dividends as a ratio of assets. 

Explanatory variables include earn 

ings, an interactive earnings variable, 

and capital, all deflated by assets. Na 

tional bank, state member bank and 

bank holding company affiliation are 

included as dummy variables. A sum 

mary of results is provided in Table 2. 

The influence of earnings and capital 

can be interpreted as the dollar 

change in dividends expected to re 

sult from a $1 change in each explan 

atory variable. The effect of the 

dummy variable must be interpreted 

as affecting the dividend-asset ratio. 

Thus, the coefficient of .0235 implies 

that national banks would be ex 

pected to distribute more dividends 

than state nonmember commercial 

banks, amounting to .0235 percent of 

bank assets. 

The model is estimated using a 

tobit estimation technique to correct 

for censoring of the dividends. Esti 

mation of the dividend model speci 

fied in equation 1 is discussed at 

length in Home (1991). Approxi 

mately one fourth of the banks paid 

no dividends, and of course negative 

dividends are not observed. Applica 

tion of standard least squares estima 

tion may generate biased and 

inconsistent parameter estimates 

16 
Bank Dividend Patterns 

under these conditions (e.g., Maddala 

(1983) or Judge <■/«/., (1985)). All the 

variables included in Table 2 are sta 

tistically significant at the probability 

level of .01. 

The data are derived from 199(1 

year-end Call Reports of FDIC-in

sured commercial banks. The final 

sample includes 12,009 commercial 

banks with mean assets of $280 mil 

lion. Mean dividends are 0.43 percent 

of assets, earnings amount to 0.67 per 

cent of assets, and capital amounted 

to 8.83 percent of assets. Approxi 

mately 32 percent of the banks in the 

sample are national banks, and eight 

percent are state Federal Reserve 

member banks. Almost 72 percent are 

affiliated with a bank holding com 

pany. 

cific values of each attribute are pro 

vided in Table 3. 

A bank with the attributes de 

scribed above would be expected to 

distribute about $920,000 in divi 

dends. This base case comprises the 

first row of Table 3. Moving down the 

table, a national bank with similar 

characteristics would be expected to 

distribute $1,037 million in dividends, 

$117,000 more in dividends than the 

amount associated with the base case. 

A state member bank with similar 

characteristics would distribute con 

siderably less, while a bank affiliated 

with a bank holding company would 

distribute almost $2.4 million, more 

than double the dividends distributed 

by a similar unaffiliatcd bank. 

Table 3 

Dividend Projections 

Attribute 

Base 

National Bank 

State Member 

Bank Holding Company 

Return on Assets = 0.50 

Capital Ratio -4.0 

To illustrate the impact of changes 

in the explanatory variables in the 

model, projected dividends based on 

the adjusted tobit coefficients are pro 

vided in Table 3 for a hypothetical 

bank. This presentation illustrates 

the impact of each variable on divi 

dends, hold ing other factors constant. 

The hypothetical bank (the base case) 

is assumed to have the following attri 

butes to simplify the comparisons: 

total assets of $500 million, earnings 

of $3.35 million (0.67 percent return 

on assets), and a capital ratio of 8.83 

percent. It is also assumed that the 

bank is a state nonmember commer 

cial bank which is not affiliated with a 

bank holding company. The ex 

pected dividends resulting from speThe large impact of class and hold 

ing company affiliation is surprising, 

and it is not clear how to account for 

the size of these effects. Differences 

in supervisory policies among regula 

tory agencies might account for some 

differences in dividend patterns. In 

addition, class and holding company 

affiliation may be correlated with vari 

ables that have been omitted, such as 

distribution of ownership, control of 

investors, type of business or geo 

graphic location. Banks affiliated with 

bank holding companies might be 

under pressure to continue dividends 

to service holding company debt. 

Banks affiliated with holding compa 

nies may also tend to pay higher divi 

dends because of tax advantages 

associated with dividends paid to the 

parent holding company. In addition, 

as bank capital becomes inadequate 

such banks need not raise capital di

rectly but may obtain transfers from 

the holding company, which in turn 

may have easier access to the capital 

markets. 

When earnings fall by $850,000 

(consistent with a decrease in the 

ROA from 0.67 to 0.50, holding every 

thing else constant), dividends are ex 

pected to fall by approximately one 

quarter of the change in earnings, or 

$209,000. Dividends would be ex 

pected to increase similarly as earn 

ings rise. If capital were less than 

three percent, dividends would be 

less sensitive to earnings, falling in 

this case by approximately $109,000. 

Capital also influences dividend 

disttibutions. High levels of capital 

may provide the resources to finance 

current dividends, even when earn 

ings are low. All other things constant, 

incteased capital reduces returns on 

equity, providing incentive to reduce 

capital by distributing additional div 

idends. Alternatively, when bank cap 

ital is inadequate, investors face a 

higher probability of bank failure. 

The ability to issue debt and equity 

secutities is also limited when a bank 

is undercapitalized, and those securi 

ties that are issued are likely to cose 

Examination of the data reveaied a small number 

of atypical banks (such as nonbank banks), wiih capital 

ratios of up to 100 percent and extraordinary dividend 

distributions rcEative to assets. Some of these banks 

hail negligible deposits; some observations represent 

the liquidation of crcdit-cacd banks that were up

streaming the proceeds to the holding companies as 

dividends. These outliers had an inordinate impact on 

the initial ordinary1 least squares estimates. The estima 

tion problem was eliminated by deleting a small num 

ber of observations representing banks with capita) 

ratios exceeding 30 percent. 

The tobit coefficients reflect the impact of the 

explanatory vaiiables on a latent or unobserved vari 

able that may be interpreted as "potential" dividends. 

For policy purposes, the effect of interest concerns 

observed {positive) dividends. Thus, the effects 

illustrated in Table Z are generated from the tobir 

^efficients which have been adjusted for the probabil 

ity of observing positive dividends (e.g., Maddala 

;9 

6 Advantages associated with bank holding com 

pany affiliation are discussed in Pozdena (198S). 

Given a capital ratio of at least three percent, the 

earnings effect is (.1284 + .1174), of just under IS 

percent of the total change in earnings. When the 

r^piial ratio is below three percent, the coefficient of 

.1264 is applied to the change in earnings. 

17 
FDIC Banking Review 

more in terms of higher debt costs or 

lower equity prices. In addition, bank 

regulators encourage banks to in 

crease capital and may impose a vari 

ety of sanctions that ultimately raise 

costs and limit the flexibility of man 

agement. Thus, the impact ofchanges 

in capital on dividends is likely to 

depend upon whether a bank is ade 

quately capitalized. 

The level of capital has a direct 

effect on dividend distributions, hold 

ing other things constant. Banks with 

higher capital ratios distribute larger 

dividends. In addition, capital has an 

interactive effect with earnings, in 

that the portion of earnings distrib 

uted as dividends is smaller for banks 

with capital ratios less than three per 

cent. The direct effect is indicated in 

the final row of Table 2 where capital 

falls from 8.83 percent to four percent 

of assets, resulting in a $539,000 divi 

dend decrease. 

The observation that banks re 

duce dividend distributions when 

capital is insufficient to meet regula 

tory standards may be interpreted as 

weak evidence that such require 

ments are effective. However, banks 

are likely to incur costs as investors 

respond to capital deficiencies, pro 

viding another incentive for under 

capitalized banks to augment their 

capital. Such banks may be required 

to offer higher yields on subordinated 

debt, pay higher rates on certificates 

of deposit, and also may experience 

an outflow of uninsured deposits. 

Owners also may desire to raise capital 

levels to avoid potential bankruptcy 

costs. To avoid such costs, undercap 

italized banks may reduce dividends 

to accumulate additional capital. Evi 

dence that undercapitalized banks re 

duce dividends, taken by itself, 

cannot be interpreted as an unambig 

uous indication of regulatory effec 

tiveness. 

The results of the empirical analy 

sis suggest that, although lower capi 

tal is associated with decreases in 

dividends, undercapitalized banks are 

permitted to distribute dividends. 

The amount of dividends distributed 

by undercapitalized banks tends to 

increase as earnings rise, holding cap 

ital constant. If distributions are fi 

nanced by bank earnings, potential 

capital is dissipated. When earnings 

are insufficient to cover dividends, 

the decline in equity capital is exacer 

bated by any distributions. Capital 

standards are a primary requirement 

for permission to receive a charter, to 

operate, and to qualify for deposit in 

surance. Permitting distributions by 

undercapitalized banks therefore rep 

resents a type of capital forbearance. 

Dividend distributions by weak or 

failing banks have led to proposals to 

restrict the dividends of undercapital 

ized banks. In the following section 

the issue of dividend restrictions and 

the implications of such a policy on 

the ability of banks to raise capital are 

discussed. The primary justification 

for permitting such distributions has 

historically been that such restrictions 

impair the ability to raise capital. 

The Impact ofDividend 

Restrictions 

The recent spate of bank failures 

has led to a renewed emphasis on cap 

ital standards. Bank regulatory agen 

cies have reached agreement on new 

leverage requirements. Moreover, 

risk-based capital requirements have 

been implemented. Despite these 

new standards, bank regulators have 

been criticized for not pursuing force 

ful enforcementactions in response to 

unsafe banking practices (e.g., GAO 

(1991a)). Dividend distributions by 

banks with inadequate earnings were 

specifically cited by the General Ac 

counting Office (GAO) as one cause 

of capital erosion for a sample of un 

dercapitalized banks. The dividend 

frequencies presented in Table 1 and 

dividend model performance esti 

mates illustrated in Table 2 provide 

additional confirmation of this source 

of capital forbearance by bank regula 

tors. Dividend distributions by under 

capitalized banks shift additional risks 

to the Bank Insurance Fund, ulti 

mately increasing failure-resolution 

costs. The GAO has proposed more 

forceful and predictable regulatory 

policies, including mandatory or 

"tripwire" policies imposing auto 

matic implementation of various re 

strictions in response to unsafe 

operating procedures (GAO (1991b)). 

One such policy would prohibit divi 

dends when capital is insufficient to 

meet regulatory standards. 

The primary justification for 

maintaining a flexible policy regard 

ing dividend distributions by under 

capitalized banks has been that, 

under certain circumstances, continu 

ation of dividends may facilitate the 

raising of capital. This is consistent 

with the observation by GAO that 

"Regulators clearly did not want to 

take an enforcement action that they 

believed would potentially damage 

the bank's ability to attract capital 

through injections, stock offerings, 

mergers, or acquirers ...." However, 

the relationship between dividends 

and the ability to raise capital is not 

clear. In this section, the theoretical 

and empirical bases that have been 

used sometimes to justify this policy 

of capital forbearance are examined. 

reduction in dividends could in 

hibit the ability of banks to raise cap 

ital if the change in dividend reduced 

the desirability of bank stock. There 

is substantial empirical evidence re 

garding the relationship between un 

anticipated changes in dividends and 

corporate stock prices. Unanticipated 

increases in dividends tend to result 

in increased prices and positive abnor 

mal returns, while unexpected reduc 

tions or omissions generally depress 

returns. The expected impact of such 

dividend restrictions on stock price, 

however, depends upon the mecha 

nism by which dividends affect price. 

Several theories most relevant to the 

issue of bank dividend restrictions are 

discussed below. 

In a world with no taxes, zero trans 

actions costs, and perfect capital mar

8 Capital falls by 4.83 percent of assets, or $24.15 

million based on assets of$500 million. Dividends fall 

by .0223 of this amount, or approximately $539,000. 

'GAO(199Ib),p.8. 
Bank Dividend Patterns 

kets, a firm's dividend policy will not 

affect its market value. This conclu 

sion is the "dividend irrelevance 

proposition" derived by Miller and 

Modigliani (1961). Investor net worth 

is independent of whether earnings 

are distributed in the form of cash 

dividends or retained by the firm. In 

vestors would be indifferent between 

receiving capital gains and dividends 

because any dividend policy of the 

firm can be duplicated exactly 

through equity transactions. If invest 

ors desire to increase cash balances, 

they can sell a fixed portion of their 

equity holdings. 

Such idealized assumptions are not 

realized in practice. Given taxes and 

transactions costs, investors may not 

be indifferent to dividend policies. 

Cash dividends generally are taxed at 

higher effective rates. Alternative 

methods of distributing dividends, 

such as share repurchases or financing 

the acquisition of other firms, may 

generate lower tax liabilities com 

pared to cash dividends. A number of 

alternative distributions to sharehold 

ers have become increasingly popular 

in recent years (Bagwell and Shoven 

(1989)). However, some categories of 

investors may have reasons to prefer 

cash dividend income. Corporations, 

for example, realize tax advantages 

from dividend income. Endowment 

funds may be restricted to spending 

dividend and interest income. Invest 

ors such as retirees who rely upon 

their assets to finance expenditures 

may prefer high-dividend stocks to 

avoid transactions costs of equity 

sales. Bank stocks, which have tradi 

tionally been considered high-yield 

investments, may attract such an in 

vestor clientele. 

There are several reasons why an 

unanticipated decrease in bank divi 

dends may depress bank stocks and 

result in abnormal returns as a result 

of such an announcement. If manage 

ment possesses superior knowledge 

regarding the earnings prospects of a 

firm, then the level of dividends may 

be used to signal these prospects to 

the market («&, Ross (1977), 

Bhattacharya (1979), Miller and Rock 

(1985)). Stock prices would be ex 

pected to move in the same direction 

as dividends to the extent that divi 

dend movements are thought to pro 

vide new information regarding 

earnings projections. Thus, a reduc 

tion in dividends might be expected 

to have an adverse impact on share 

values as investors interpret the policy 

change to indicate lower earnings ex 

pectations of management. number 

of studies demonstrate the impact of 

dividend announcements on prices 

after controlling for earnings an 

nouncements. Dividend cuts and 

omissions appear to have a particu 

larly marked impact. Several studies 

(e.g., Healy and Palepu (1988) and 

Manakyan and Carroll (1990)) test the 

relationship between dividend an 

nouncements and subsequent earn 

ings directly, and find that 

announcements of dividend initia 

tions and omissions predict earnings. 

Small price responses to subsequent 

earnings announcements imply that 

investors use dividend announce 

ments to form their expectations of 

future earnings. 

The impact of a dividend reduc 

tion might be greater for banks with 

relatively higher dividend distribu 

tions than for firms with lower divi 

dend yields if the marginal investor in 

bank stocks prefers dividends relative 

to capital gains. This would be consis 

tent with a clientele effect. Bajaj and 

Vijh (1990) provide evidence that 

changes in dividends have a greater 

impact on prices for those stocks with 

high dividend yields. They argue the 

price adjustment may be separated 

into two components. First, a de 

crease in dividends may signal lower 

earnings to investors, which would re 

sult in lower prices, other things con 

stant. This is consistent with the 

signaling effect. The second compo 

nent of price adjustment, the clien 

tele effect, may work in either 

direction depending upon the prefer 

ences of the marginal investor. If the 

marginal investor in a particular stock 

prefers a relatively high dividend 

yield, the announcement of a lower 

dividend yield would reduce the 

value of this stock relative to other 

stocks at the margin, placing further 

negative pressure on its price. If such 

a clientele effect were to influence 

prices, bank stock prices might be 

more sensitive to changes in dividend 

policies than other nonbank firms. 

The signaling aspect of dividend 

changes is eliminated if dividend Jev

els are determined exclusively on the 

basis of observable information, be 

cause no new information would be 

revealed by a suspension of divi 

dends. Thus, automatic dividend re 

strictions based upon capital ratios, 

which are widely available, should not 

lead to lower equity prices in response 

to a signaling effect because informa 

tion asymmetries would not exist. 

However, some price adjustment on 

the basis of a clientele effect might 

result, although this effect may be 

considered somewhat tenuous. 

Although dividend restrictions 

based on observable criteria would 

eliminate the signaling response of 

stock prices, signaling may be partially 

responsible for the capital forbear 

ance or "flexibility" demonstrated by 

bank regulators in the past. Much in 

ternal information, such as bank 

CAMEL ratings and informal regulaAlthough the current nominal tax rates on capital 

gains and dividend income are equivalent, the effec 

tive rates may vary. Taxes on capital gains may be 

deferred until the gains are realized. Moreover, in 

some circumstances capital gains may be avoided by 

passing assets through estates or by using gains to 

offset capital losses from other sources. 

11 Miller andModigliani(l%l)and Black and Scholes (1974) discuss investor preferences for high-yield stocks. 

Examples of this literature include Aharony and 

Swary (1980), Asquith and Mullins (1983), Brickley 

(1983), Dielman and Oppenheimer (1984), and Kalay 

and Loewenstein (1985). 

Examples include Healy and Palepu (1988) and 

Ghosh and Woolridge (1988). 

As Bajaj and Vijh note, "there seems to be no 

consensus on the clientele hypothesis" (p. 194). A 

clientele effect under these circumstances would be 

eliminated if investors could fully adjust their portfo 

lios. A decrease in dividends relative to capital gains 

may reduce the value of the stock to investors with 

preference for high dividend yields, but tJic stock 

should become more attractive to investors desiring 

capital gains. Litzenberger and Ramaswamy (1980, 

1982) suggest that short-sale and margin restrictions 

may limit the ability of investors to fully adjust their 

portfolios and thus generate a clientele effect. 
FDIC Banking Review 

tory actions in response to unsafe 

banking practices, is not available to 

the public and therefore is not ob 

served by potential investors. How 

ever, investors may observe that a 

particular banking institution, despite 

inadequate capital, is permitted to 

continue distributing dividends. 

Under these circumstances,investors 

might conclude that, despite the cur 

rent capital deficiency, both manage 

ment and bank regulators (who 

presumably monitor undercapitalized 

banks closely) believe the bank's fi 

nancial condition is adequate to sup 

port such dividends. Thus, under the 

current system, regulators may permit 

continued dividends in order to signal 

investors that the bank is likely to be 

viable with an infusion of capital. In 

terruption of dividends could be in 

terpreted by investors as a signal that 

regulators possess additional negative 

information regarding the financial 

condition of the bank. 

Regulators might be reluctant to 

prohibit dividends if such a policy 

were thought to inhibit new invest 

ment. By attracting new capital, bank 

regulators shift some of the risk and 

potential failure-resolution costs to in 

vestors. However, if dividend restric 

tions were determined on the basis of 

an objective measure, such as equity 

capital, this potential source of signal 

ing would be eliminated. 

Dividend restrictions may have an 

indirect impact on share value by in 

fluencing the probability that the un 

dercapitalized bank will survive. 

Undercapitalized banks have a very 

high probability of failure, an attri 

bute that may dominate the market 

valuation. Once a firm is closed, both 

current and future dividends are elim 

inated. Moreover, in the event of 

bank failure, investors rarely recover 

any residual value because (a) bank 

ruptcy costs can be substantial, and 

(b) equity capital measured according 

to generally accepted accounting 

principles (GAAP) is likely to over 

state the value of the bank. A divi 

dend restriction would eliminate 

current dividends if capital were inad 

equate. But once capital standards 

were met, dividend distributions 

could be resumed. The dividend re 

striction is intended to encourage an 

increase in capital through retained 

earnings, and may be perceived as in 

creasing the probability of survival. 

The sum of the direct and indirect 

effects of dividend restrictions on 

share value, given the previous dis 

cussion, is ambiguous, but is also 

likely to be relatively small under 

most conditions. The exception may 

be where bank failure is imminent, in 

which case the value of the bank may 

be entirely dependent upon the 

amount of dividends that may be dis 

tributed before the bank is closed. 

Permitting undercapitalized banks to 

distribute dividends creates a moral 

hazard problem: the incentives to de 

clare dividends are greatest for banks 

with the highest probability of failure. 

When bank failure is imminent, in 

vestors have incentives to exaggerate 

the financial condition of the bank, 

delay bank closure, and distribute as 

much capital as possible in the form of 

dividends. The moral hazard problem 

is exacerbated by the fact that regula 

tory net worth, as measured under 

GAAP, typically would substantially 

exceed the going-concern value of an 

undercapitalized bank. This differ 

ence in value may be exacerbated by 

recognizing gains on the sale of se 

lected assets and holding other assets 

that have depreciated more rapidly. 

When GAAP net worth reaches zero, 

the liquidation value of the bank can 

be substantially negative. 

The discussion of dividend restric 

tions has focused primarily on bank 

equity. However, restrictions on divi 

dends would be expected to have an 

unambiguously positive effect on the 

value of bank debt. Dividend restric 

tions are a normal part of bondholder 

covenants to protect the interest of 

the bondholders. To the extent that 

dividend restrictions reduce the risks 

associated with debt instruments, the 

costs of debt should fall, ether things 

constant. Therefore, dividend restric 

tions should facilitate the ability of 

banks to issue subordinated debt. 

Dividend restrictions on common 

stock should also have an unambigu 

ously positive effect on the value of 

preferred equity, although the size of 

the effect may be small. Any reduc 

tion in the distributions to common 

stockholders increases the amount of 

capital available to satisfy competing 

claims on bank assets. Restrictions on 

preferred stock dividends have also 

been proposed. The impact on pre 

ferred equity value would be similar 

in nature to the effect of dividend 

restrictions on common stock: the loss 

in value associated with the current 

dividend foregone would be at least 

partly offset by the impact of in 

creased capital on the probability of 

survival and thus the probability of 

continued dividend payments in the 

future. The dynamics are slightly dif 

ferent with respect to preferred stock, 

because normally the dividends on 

preferred stock continue to accrue. 

Actual distribution would occur only 

if the bank subsequently achieved ad 

equate capitalization. Otherwise, 

upon bank closure the accrued funds 

would be available to satisfy the 

claims of creditors. 

These theoretical considerations 

suggest that dividend restrictions 

should not affect the ability of a bank 

to raise capital. Limited empirical ev 

idence supports this conclusion. To 

investigate the relationship between 

dividends and the ability to raise cap 

ital, a sample of undercapitalized 

banks was analyzed. At the end of 

1986, 301 commercial banks exhib 

ited capital ratios of three percent or 

less. These banks were tracked 

through 1989. Of these, just over half 

(161) failed. Surviving banks gener 

ally accumulated capital from re 

tained earnings, contributions from 

the parent holding company, security 

issues, or some combination of these 

methods. Ability to retain earnings 

was limited; most banks experienced 

losses over the three years. Only 48 

banks in the sample experienced pos 

itive earnings on average over the 
Bank Dividend Patterns 

three subsequent years. Forty-seven 

banks received some aid from the par 

ent holding company, and 56 raised 

capital by issuing some type of secu 

rities. It is also interesting to note the 

relative amounts of capital raised by 

the different approaches over the 

three years. For the banks that sur 

vived, approximately $161 million 

were raised by issuingsecurities, com 

pared to $342 million in transfers from 

the parent holding company. For 

these same surviving banks, $95 mil 

lion were paid out in dividends from 

1987 to 1989. 

Most undercapitalized banks did 

not distribute any cash dividends dur 

ing the three years. Between 1987 and 

1989, only 26 banks in the sample 

distributed dividends. Of these 26 

banks, only one failed, which suggests 

that banks paying dividends were 

likely co be in better condition than 

the average bank in the sample. 

Moreover, the bulk of the dividends 

that were paid out were distributed by 

banks after sufficient capital had al 

ready been raised to meet require 

ments. It is interesting that of the 56 

banks that issued securities to raise 

capital, only ten of these distributed 

any dividends over the three-year pe 

riod. Similarly, of the 47 banks that 

received funds from the parent hold 

ing company, only 12 distributed div 

idends. 

This sample is relatively small, and 

one should generalize to other years 

with caution. However, the evidence 

suggests that undercapitalized banks 

can attract capital without distribut 

ing dividends. Even after recapitaliza 

tion, few of the surviving banks 

restored dividends within the time 

horizon. Under these conditions, it 

seems unlikely that a dividend restric 

tion would have had much impact on 

the recapitalization process. 

Several other papers report similar 

findings using larger samples of un 

dercapitalized banks. Gilbert (1991) 

examined banks that did not meet 

primary capital requirements (5.5 per 

cent of assets) for five or more consec 

utive quarters during the period 1985 

co 1989. By the end of 1989, the recov 

ery rate for banks paying dividends 

exceeded the rate for those not paying 

dividends, although the difference in 

rates was not found to be statistically 

significant. Gilbert concluded that 

these results "do not provide empiri 

cal support for the view chat manda 

tory constraints on the behavior of 

undercapitalized banks will reduce 

the bank failure rate." 

Da hi and Spivey (1991) also ana 

lyzed banks that were undercapital 

ized, using observations from 1981 to 

1988. Recovery time (where recovery 

is assumed when primary capital re 

quirements are met) is modeled in a 

regression framework as a function of 

annual changes in assets, earnings, 

dividends and equity issues. Dahl and 

Spivey found only the equity issue 

variable significant in influencing re 

covery. Based on the lack of a statisti 

cally significant dividend effect, the 

authors concluded that: "The insig 

nificance of dividend policy on recov 

ery fails to provide empirical support 

for the popular notion that dividend 

restrictions on banks which are under 

capitalized, or unprofitable, would re 

duce losses for deposit insurers. In 

fact, such restrictions may be counter 

productive to the extent that 'lower 

dividends make it harder for (bank 

ers) to raise equity at exactly the time 

they're facing tougher regulatory re 

quirements for capital. i ,.16 

Dividend restrictions may reduce 

the FDIC's costs even if the number 

of bank failures were not reduced. For 

banks that do eventually fail, divi 

dend restrictions eliminate an addi 

tional source of capital impairment. 

Other things equal, the more capital 

that is available when the bank faits, 

the lower the costs to the deposit in 

surer. Lack of statistical significance 

in a bank recovery model does not 

imply chat dividend restrictions 

would generate no cost savings, much 

less thacchis policy would be counter 

productive. 

Moreover, methodological prob 

lems with these analyses cast some 

doubt on the validity of the conclu 

sions concerning the effect of divi 

dends on bank recapitalization. The 

banks in the best relative financial 

condition, which are therefore most 

likely to recover from capital deficien 

cies, are also those banks most likely 

to continue dividend distributions. 

This factor could be responsible for a 

positive correlation between divi 

dends and recovery. It would be inap 

propriate to conclude from such 

evidence that dividend increases 

therefore contribute to recapitaliza 

tion. The dividend model discussed 

in this paper demonstrates the posi 

tive impact of capita! and earnings on 

dividends. Because no correction is 

made for this source of sample selec 

tion, the results of Gilbert and Dahl 

and Spivey regarding the role of divi 

dends on bank recovery should be 

interpreted with caution. 

The contribution of dividends on 

the ability of banks to issue equity was 

not investigated directly by Dahl and 

Spivey, although the authors esti 

mated a model of bank equity issues. 

Equity issues are specified as a func 

tion of bank capital and other vari 

ables, similar to Dahl and Shrieves 

(1990). Unforcunacely, this model is 

also subject to specification problems. 

Observed equity issues reflect both 

markec demand for bank equity by 

investors and supply of equity by 

banks. It is not possible to identify in 

the econometrics sense either supply 

or demand by applying least squares 

to a single-equation model. In anal 

yses that include all banks, given the 

relatively large number of ade 

quately-capitalized banks compared 

to undercapitalized banks, one would 

expect the supply effect to dominate: 

well-capitalized banks have little in 

centive to issue equity, while banks 

15 Gilbert, p. 8. 

Dahl and Spivey, p. 13, citing the Wall Street 

Joan^ADecember 19, 1990, p. 3). 

In a simultaneous-equation framework, capital is 

likely tn influence both demand and supply of equity, 

lisiimation of the structural equations by ordinary least 

squares yields inconsistent estimators of the regression 

parameters. 

21 
FDIC Banking Reveiw 

with less capital desire to issue equity. 

Under these circumstances, more eq 

uity issues would be observed as cap 

ital falls. Alternatively, in analyses 

restricted to undercapitalized banks, 

given chat these banks are likely to 

desire additional equity, observed eq 

uity issues may be constrained pri 

marily by investor demand for bank 

equity- Investors are likely to be wary 

of investing in those banks experienc 

ing the greatest capital deficiencies. 

One would expect to observe the fre 

quency of equity issues to rise with 

capital based on analysis of undercap 

italized banks. Thus, it is not surpris 

ing that equity issues are positively 

related to bank capital of undercapi 

talized banks, as in Dahl and Spivey, 

but negatively related to capital when 

applied to all banks, as in Dahl and 

Shrieves. Dahl and Spivey attribute 

the different capital effects to chang 

ing incentives, suggesting that the 

most undercapitalized banks choose 

not to raise capital in response to 

"greater incentives to engage in risktaking behavior." 

In short, results from the analyses 

of undercapitalized bank samples 

must be interpreted with caution. Ca 

sual observation suggests that many 

banks that are successful in issuing 

equity do not distribute dividends; 

dividend distributions do not appear 

to be a prerequisite for equity issues. 

Unfortunately, conclusions regarding 

the role of dividend restrictions on 

recapitalization or equity issues based 

on Dahl and Spivey should be re 

garded with some skepticism. We 

now turn to the issue of current divi 

dend restrictions. 

The Office of the Comptroller of 

the Currency (OCC) and the Federal 

Reserve impose some objective re 

strictions on dividend distributions. 

National and Federal Reserve mem 

ber banks face two primary restric 

tions on dividends under Sections 56 

and 60 of the National Bank Act. The 

first, a capital limitation, limits divi 

dends to undivided profits on hand 

(12 U.S.C. 56). Undivided profits are 

synonymous with accumulated re 

tained earnings. This capital limita 

tion must be met before dividends are 

distributed. The earnings limitation 

restricts dividend payments to net 

profits in the current year in addition 

to net profits retained from the previ 

ous two years (12 U.S.C. 60). If a bank 

does not meet the earnings limitation, 

dividends may be distributed only 

with permission from the primary reg 

ulator. The dividends of state non

member banks are regulated by the 

states, of which some impose restric 

tions similar to those of Sections 56 

and 60. In contrast, the FDIC does 

not impose specific quantitative divi 

dend restrictions, unless deposit in 

surance assessments are in default, 

although dividends may be restricted 

on safety-and-soundness grounds by 

cease-and-desist orders or other en 

forcement actions. 

Sections 56 and 60 do not explicitly 

prohibit dividends by undercapital 

ized banks, although changes in the 

treatment of the allowance for loan 

and lease losses make such distribu 

tions more difficult. Until recently, 

the allowance for loan and lease losses 

could be added to undivided profits, 

weakening the capital limitation. 

Similarly, banks were permitted to 

add the provisions for loan and lease 

losses to reported net income for the 

purpose of meeting the earnings lim 

itation. The OCC and the Federal 

Reserve no longer permit these ad 

justments to undivided profits or net 

income. 

The policy of permitting under 

capitalized banks to continue to dis 

tribute dividends is difficult to justify 

on either theoretical or empirical 

grounds. Such dividend distributions 

reduce capital further and shift addi 

tional risks to creditors and the FDIC. 

Allowing such dividends creates a 

moral hazard problem because own 

ers have the most incentive to distrib 

ute dividends when bank failure is 

imminent. There is no evidence to 

suggest that reduced dividends either 

limit the ability of undercapitalized 

banks to raise capital or reduce the 

time to recover from capital deficien 

cies. 

The impact of dividend restric 

tions, however, may be limited as a 

consequence of the ability of manage 

ment to allocate dividends and provis 

ions for loan and lease losses over 

time. Dividends are generally de 

clared over the first two to three quar 

ters, whereas provisions for losses are 

commonly taken in the final quarters. 

The majority of banks that were un 

dercapitalized by year-end, and which 

distributed dividends during the year, 

declared their dividends in the early 

quarters when regulatory capital was 

reported to be adequate. Im 

plementation of dividend restrictions 

may have a limited impact on divi 

dend distributions, and could result in 

greater delays in recognizing losses to 

protect desired dividend distribu 

tions. Therefore, automatic dividend 

restrictions based on capital will be 

ineffective if reported capital does not 

adequately represent the financial 

condition of a bank. 

Conclusions 

Commercial bank dividends on 

common stock increased steadily over 

the 1980s, from $5.1 billion in 1980 to 

$14.0 billion in 1989, substantially ex 

ceeding the growth of earnings. The 

rise in dividends relative to earnings 

has led some observers to characterize 

bank dividend distributions as exces 

sive. On the basis of equity capital 

ratios, such concerns might appear to 

be unwarranted. Earnings exceeded 

dividends in each year but one, and 

equity capital increased relative to as 

sets. The aggregate equity capital 

ratio in 1990, for example, reached 

almost 6.5 percent, compared to 5.6 

percent in 1980. However, the aggre 

gate statistics conceal two problems. 

First, reported equity capital is over 

stated to the extent that the banking 

industry is considered iiable for the 

shortfall in the Bank Insurance Fund. 

Although not reported on bank bal 

ance sheets, from an economic per

sDahlandSpivey,p.16 

An overview ofdividend restrictions is provided 

in Conner and DeWiit (1991). 

22 
Bank Dividend Patterns 

exceed annual earnings by a consider Automatic dividend restrictions spective the Fund deficit may be re 

may be useful to prevent further ero garded as an industry liability. If re able margin. In 1989, for example, 

sion of equity capital in banks not ported equity capital were adjusted some 322 commercial banks that were 

meeting capital requirements. Re for this source of implicit liability, eq undercapitalized by year-end paid 

strictions based on objective, observ uity capital on an adjusted basis would $1.7 billion in dividends during the able criteria would eliminate the appear to have fallen in recent years. year, while as a group these banks negative repercussions normally asso As a consequence, more risk has been sustained losses totalling $6.7 billion. ciated with the signaling aspect of de shifted to the FDIC. Such practices raise valid public-pol creased dividends. Both theoretical 

icy concerns. Although the adverse Second, the aggregate numbers considerations and limited empirical 

conceal substantial variation in divi impacts of capital erosion are well- evidence indicate that such restric 

dends across banks with different cap known, analyses of individual-bank tions are not likely to inhibit a bank's 

ital rates. A large number of banks, data indicate that dividend distribu ability to raise capital. 

including some undercapitalized tions by undercapitalized banks are 

banks, distribute dividends chat may not uncommon. 

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24 
A Framework For Analyzing Deposit Insurance Pricing 

Framework For Analyzing 

Deposit Insurance Pricing 

by Christine E. Blair and Gary S. FisseP 

One facet of the current debate 

on deposit insurance reform 

concerns the desirability and 

feasibility of a risk-based deposit 

insurance system. Under such a 

system, the deposit insurance 

assessment would be related to the 

degree of risk that an insured 

institution poses to the deposit 

insurance funds administered by the 

Federal Deposit Insurance 

Corporation (FDIC). The question of 

whether to revise trie current system 

af flat-rate deposit insurance 

premiums in favor of a risk-based 

system is not new. However, the 

recent losses incurred by the deposit 

insurance funds for thrifts and 

commercial banks have given this 

issue a renewed urgency. 

Under the current flat-rate deposit 

insurance system, all FDIC-insured 

depository institutions are assessed at 

the same rate for their deposit insur 

ance coverage. These premiums are 

invariant to the level of risk that a 

bank poses to the insurance funds." 

The system of flat-rate premiums has 

been criticized for encouraging exces 

sive risk-taking by insured institu 

tions and inequitably distributing the 

burden of insurance losses among 

banks. The current flat-rate system 

allows a bank to increase the risk in its 

portfolio without incurring any addi 

tional insurance premium expense. 

Moreover, it is argued that "high

risk" institutions are receiving a sub 

sidy on their deposit insurance 

coverage at the expense of "low-risk" 

institutions. These considerations 

would support a system in which in 

stitutions with riskier portfolios 

would be assessed a higher premium 

for their deposit insurance coverage. 

On this basis, it is argued that a 

system of risk-based premiums could 

alleviate some, if not all, of the subsi 

dies and inequities associated with 

[he current flat-rate system. If so, riskbased premiums would represent a 

major step toward a more equitable 

and efficient banking system. How 

ever, it also must be determined 

whether it is possible to design a prac 

tical risk-based system that will 

achieve these goals. 

The purpose of this paper is to 

examine the conceptual framework of 

deposit insurance pricing. First, sev 

eral important issues concerning de

• The authors are financial econoniistsinihcFDJC's Division of Research and Statistics. They would like loihank George French and Frederick Cams fur their useful commenis 

and suggestions, and Lynn Nejezctileb for his contri bin ions to this paper. 

Over ihc pasi decade, ihc banking and ihrift industries, i heir regulators, anil the Congress have been engaged in an ongoing discussion of ihe desirability and feasibility of a 

risk-based deposit insurance system. Risk-based premiums have been examined as par[ of the studies required of the banking agencies under the Gar n-St Germain Aciof 1982, 

These include the FDIC's Drposi/ Insurance in Changing Environment and the Federal Home Loan Bank Board's hgeitdafor Rejorm As well, risk-based deposit insurance has been ^wx,— ! j*xl lx. j »lx~ I I C ("'««^^, I A 1.x-.. .x* .x x. *~\{1~... ' . ._ . CT __ J. I\ .m. . . 'm t _. ... a . . • -. . r t\ r n . -■

The deposit insurance systems of ether industrialized countries have premium structures thai fall into two cancgories. One approach, similar to the current UrS. premium 

structure, assesses an insured insulation at a far rate of us deposit base. The oiher approach involves ihc assessment of participating msiixiiiions based on losses mthe insurance 

fund during rhe year, with seme ceiling cm an insr.nu[ion's comribution. France and Italy use ihis approach. There arc ether counlrics whose approach to funding their deposit 

insurance syiiems intcgraies clemenis from each of these two approaches. For example^ Britain's premium structure requires some initial tcintribiiiion from its insured msiitutiGns, 

with fu rt her as segments, being called when necessary. 

From ihis point (in, unless otherwise siaied, the term "bank" will refer to any insured depository institution. 
FDIC Banking Review 

posit insurance are considered. Next, 

an overview of several alternative 

methods for establishing risk-based 

premiums is presented, followed by a 

discussion of the advantages and dis 

advantages of these approaches to the 

so-called "pricing problem." The 

paper concludes with a few summary 

comments. 

Issues Regarding the Pricing of 

Deposit Insurance 

Mispricing and Risk-Taking 

A deposit insurance pricing mech 

anism that fails to account for the risk 

that an insured institution poses to the 

insurance fund potentially has two 

undesirable effects: (i) the subsidiza 

tion of high-risk banks by low-risk 

banks for deposit insurance coverage 

and (ii) the provision of incentives for 

increased risk-taking by banks. 

Premiums as a Subsidy or Tax. A 

fundamental principle of pricing in 

most insurance settings holds that an 

insured who poses a greater financial 

risk to the insurer per dollar of cover 

age should be assessed at a higher rate 

than an insured who poses a lesser 

risk. In a setting in which all insureds 

pay the same rate and the insurer re 

ceives sufficient revenues to cover 

costs, the low-risk insureds are paying 

for part of the benefit that is received 

by the high-risk insureds. This is true 

under the current flat-rate premium 

structure for deposit insurance: banks 

chat pose less risk to the insurance 

fund, because they are well-capital 

ized and hold assets and liabilities that 

are not excessively risky, subsidize 

the deposit insurance coverage of 

high-risk banks. 

Moral Hazard. Mispriced deposit 

insurance most often is discussed in 

terms of its implications for the risktaking behavior of depository institu 

tions. The current flat-rate system has 

been alleged to create incentives for 

banks to increase their portfolio risk. 

Market participants normally are con 

fronted with a risk/return trade-off: 

higher yields can be obtained only at 

the expense of greater risks. Specific 

ally, in the absence of deposit insur 

ance, the gains that stockholders may 

realize from moving to riskier posi 

tions would be limited by depositors, 

who would demand additional com 

pensation for increased risk-taking by 

the bank. 

With deposit insurance, insured 

depositors hold an asset whose value 

is independent of the solvency posi 

tion of the bank, and so no credit-risk 

premium is required by these deposi 

tors. Moreover, under a flat-rate pre 

mium structure, banks' insurance 

costs will be the same regardless of 

their risk positions. As a result, banks 

may take on additional risk without 

having to pay higher interest rates on 

deposits or higher insurance premi 

ums. The risk/return trade-off has 

been altered such that the price of 

assuming greater risk has been re 

duced and, consequently, the bank 

has an incentive to move to a riskier 

position. 

After granting insurance, the in 

surer must guard againstactions taken 

by the insured that would increase the 

insurer's potential loss. The signifi 

cance of this "moral hazard" problem 

depends on the extent to which the 

insured has incentives to take actions 

that increase his or her risk and the 

extent to which these actions are un

observable by the insurer. In many 

insurance settings, moral hazard is 

controlled by making the insurance 

payout contingent on the insured 

party acting in a specified manner. 

For example, an insurance company 

will not pay off on fire damage if the 

insured party commits arson. How 

ever, payouts to depositors contingent 

on bank behavior may not be desir 

able, since it would reintroduce the 

problem of bank runs. Alternatively, 

the moral hazard problem may be 

dealt with by monitoring bank behav 

ior, for example, through examina 

tions, and imposing penalties on 

managers and owners when undesir 

able behavior is observed. 

Countervailing Factors 

There are factors apart from the 

pricing of deposit insurance that can 

limit the degree of risk-taking by in 

sured institutions that is, the moral 

hazard problem. 

Market Discipline. To the extent 

that uninsured liabilities are at risk, 

these debt holders will exert some 

discipline on bank risk-taking. In ad 

dition, the owners of an institution 

have an important stake in its survival. 

Provided that they have invested suf 

ficient capital and are sufficiently 

risk-averse, owners would be ex 

pected to place limits on 

management's risk-taking activities. 

Thus, even under the current flat-rate 

system, the market discipline im 

posed by uninsured creditors and 

owners can limit the risk-taking be 

havior of institutions. 

Regulatory Discipline. In practice, a 

bank's risk-taking also can be limited 

by costs imposed by the regulatory 

oversight of its activities. Regulators 

periodically examine banks to deter 

mine if they are being operated in a 

safe-and-sound manner, and undesir 

able behavior is penalized through is 

suance of cease-and-desist orders, 

removal of bank officers or directors 

for certain violations, and the levying 

of fines. In addition, regulations pre 

vent insured institutions from engag 

ing in certain financial activities and 

set minimum capital requirements. 

These regulations and supervisory 

sanctions limit the ability of banks to 

engage in overly risky activities and 

represent an implicit cost of deposit 

insurance. To the extent that these 

implicit costs vary with the riskiness 

of the bank, they may perform the 

same function as a system of riskbased premiums and constrain risktaking. 

Moral hazard refers to a situation where an agent 

cannot be perfectly monitored by a principal, and has 

an incentive to act contrary to the interests nf the 

principal. 

26 
A Framework For Analyzing Deposit Insurance Pricing 

General Problems in 

Pricing Bank Risk 

The pricing of bank risk is difficult 

for the insurer primarily because of 

the problems of accurately measuring 

the risk that each bank poses to the 

insurance fund. 

Ex Ante vs. Ex Post Risk. Nearly all 

insurance settings are characterized 

by asymmetric information concern 

ing the insured's risk type, i.e., the 

insured possesses better information 

about his or her risk type than does 

the insurer. For example, automobile 

drivers know their own driving pat 

terns and behavior better than the in 

surer and, if they were honest with 

themselves, could better assess their 

own risk than could the insurer. How 

ever, high-risk drivers have incentives 

to hide their true risk characteristics 

and to pose as low-risk types. Insurers 

attempt to bridge the information gap 

by using actuarial information to 

make judgments about a driver's risk' 

type based on age, sex, or other ob 

servable characteristics. This type of 

information can be gathered by the 

insurer prior to any outcomes that are 

covered under the insurance contract 

being observed. This is referred to as 

ex ante information. In addition, the 

insured's driving record (traffic tick 

ets, accidents, etc.) can be used to ob 

tain information about the driver's 

risk type. This information is avail 

able to the insurer only after outcomes 

that are covered under the insurance 

contract are observed, and is referred 

to as ex post information. Of course, 

even with this information the insurer 

will not know the driver's true risk 

type with certainty. 

Although automobile insurance 

differs from deposit insurance in 

many respects, the example 

illustrates the general problems asso 

ciated with asymmetric information. 

Just as in the case of drivers, banks 

possess more information about their 

risk type than does the FDIC. More 

over, determining a bank's risk type 

ex ante is arguably more difficult than 

in most insurance settings. A major 

function of banks is to assess the risks 

of lending to borrowers for whom 

there is little information on theireco

nomic condition and prospects. 

Thus, banks specialize in obtaining 

information about the very events, 

credit risks, that are most likely to 

result in a loss to the insurer. Because 

of this specialized knowledge, the ex 

ante information gap between the in 

surer and the insured is perhaps larger 

than in most other insurance settings, 

and is one of the most important rea 

sons for the inability to find good ex 

ante measures of risk. 

While there are steps that the in 

surer could take to increase the infor 

mation concerning the risks of 

specific institutions, at some point the 

costs of acquiring this information be 

come prohibitive. On the other hand, 

the use oiexante measures that are not 

based on information that is specific 

with respect to an institution's credit 

risks or other portfolio risks would 

likely be ineffective and, more im 

portantly, potentially influence risktaking behavior and credit allocation 

in undesirable ways. Therefore, while 

ex ante measures of risk are conceptu 

ally preferable, most proposals for 

risk-based premiums have used ex 

post measures of risk. 

AdverseSelection. Asymmetric infor 

mation regarding the insured's risk 

type results in two problems for the 

insurer: (i) controlling the insured's 

risk-taking once insurance is granted, 

i.e., the moral hazard problem dis 

cussed above; and (ii) correctly classi 

fy ing the insured's risk type, 

sometimes referred to as the "adverse 

selection" problem. The insured is 

assumed to know its risk type while 

the insurer must make a judgment 

about the insured's risk type. In an 

insurance setting where the cost of 

insurance increases with the risk of 

the insured, the insured has an eco 

nomic incentive to appear as a lowerrisk client to the insurer. 

The insurer can reduce the ad 

verse-selection problem by obtaining 

more information about the client. Of 

course, the benefits of greater infor 

mation, such as more appropriately 

priced insurance, would have to be 

weighed against the costs of the addi 

tional resources needed to obtain the 

relevant information. Another solu 

tion is to offer "incentive-compati 

ble" contracts. For example, 

automobile insurers offer varying 

amounts of deductible insurance in 

combination with different premium 

rates. If a driver feels that he or she is 

a particularly safe driver, he or she 

probably will opt for a relatively highdeductible, low-premium contract, 

and viceversa for a high-risk driver. By 

allowing insurance contracts to vary 

by more than one characteristic, for 

example, price and coverage, the in 

centive-compatible contract is de 

signed to induce insureds to signal 

their true risk type. 

An incentive-compatible deposit 

insurance contract could involve of 

fering banks the choice of various 

price/capital combinations. Banks 

that choose higher capital levels 

would pay lower insurance premiums, 

and viceversa. The idea is that obtain 

ing additional capital would be less 

expensive for low-risk banks than for 

high-risk banks. Thus, low-risk banks 

would prefer to select a high-capi 

tal/low-premium combination, while 

the opposite would be true for highrisk banks. The goal would be to es 

tablish the deposit insurance contract 

that results in a more accurate rela 

tionship between insurance premi 

ums and risk. 

Estimating Long-Run Bank-Failure 

Costs. In banking, it may be difficult 

for the insurer to determine when the 

premium revenues from a particular 

risk group of banks are sufficient to 

cover their expected failure costs. In 

casualty insurance, this is relatively 

easy because the events being in 

sured against are independent events 

that are fairly evenly distributed over 

time. As a result, an automobile in

'JpfGoodliart (1987), p.86, for a discussion ofchis 

issue. 

JThe term incentive-compatible means chat there 

arc incentives for the insureds to choose the pre 

mium/at tribute combination that is appropriate for 

their risk class. 

27 
FDIC Banking Review 

surer will learn quickly whether the 

premium revenues are sufficient to 

cover the long-run costs of any risk 

category. However, bank failures are 

not evenly distributed over time. In 

stead, they tend to be associated with 

the business cycle or economic 

shocks. Consequently, the setting of 

premium rates for different risk 

groups so that the long-run revenues 

are sufficient to cover the long-run 

costs of each risk category is more 

difficult.7 

Proposals for Risk-Based 

Premiums 

There is widespread acceptance 

that a flat-rate premium structure, by 

itself, creates perverse incentives to 

ward greater risk-taking and penalizes 

more-conservatively-run institutions. 

There is less agreement whether a 

more explicit risk-related pricing sys 

tem could be developed that would 

be a significant improvement over the 

current system. A number of propos 

als for establishing risk-related premi 

ums have been made; each has 

advantages and disadvantages when 

compared to the current system. 

These proposals generally can be cat 

egorized into those that try to incorpo 

rate the market's assessment of bank 

risk and those that rely on the public 

insurer's assessment of risk. 

Market-Based Risk 

Assessments 

One line of reasoning argues that 

the pricing of deposit insurance could 

be improved if deposit insurance were 

assessed at a rate equivalent to the 

risk premium required by the market 

for bearing the same risk of loss as the 

federal insurer. The success of this 

pricing approach depends, in large 

part, on whether an accurate measure 

of this market-based risk premium 

can be obtained. Several approaches 

that rely on the use of market informa 

tion to price deposit insurance are 

found in the literature, including: (i) 

the risk premium required by the 

market on uninsured deposits; (ii) the 

use of integrated systems of public 

and private insurance; and (iii) option 

pricing theory. 

Interest Rates on Uninsured Deposits. 

Because deposit insurance provides 

explicit coverage for deposits of 

$100,000 or less, leaving uninsured 

those deposits greater than $100,000, 

it has been proposed that deposit in 

surance premiums could be deter 

mined from the market rates paid on 

uninsured deposits (Peltzman (1972), 

Thomson (1987)). Fundamental to 

this approach is the idea that deposi 

tors will demand a risk premium if 

they perceive that their uninsured de 

posits are at risk. Since depositors 

could place their uninsured funds in 

an alternative investment with the 

same level of risk, they should de 

mand a risk premium commensurate 

with the bank's risk. 

Thomson (1987) shows that under 

certain conditions the risk premium 

paid on uninsured deposits can be 

used to provide, at a minimum, a 

benchmark or lower bound for the 

fair-value deposit insurance pre 

mium. Specifically, "if banks are 

closed when they are found to be in 

solvent and if uninsured depositors 

and stockholders bear their full share 

of losses, then the fair value of the 

deposit guarantee on $1 of insured 

deposits is the risk premium paid on 

$1 of uninsured deposits." This re 

sult is based on conditions that are 

somewhat restrictive, assuming, 

among other things, efficient, friction

less markets and the issuance of un

conditionally uninsured deposits. 

In practice, due to the existence of 

market imperfections, the observed 

risk premium would be expected to 

be a lower bound for the "true" pre 

mium. Notably, investors may per 

ceive that depositors of large banks 

will not be allowed to suffer losses. 

This expectation of de facto coverage 

for uninsured deposits may obviate 

the need for uninsured depositors to 

demand an appropriate risk premium, 

especially in the case of large banks. 

Also, if insurance premiums were 

based on the market rates paid on 

uninsured deposits, riskier banks 

would have an incentive to parcel 

large, otherwise uninsured, deposits 

into multiple insured accounts. Con 

sequently, the observed risk premi 

ums would not reflect the full range of 

bank riskiness that ideally would be 

captured in a risk-based deposit insur 

ance assessment. 

Given de facto coverage of unin 

sured deposits and the presence of 

market imperfections, it is likely that 

the rate paid on uninsured deposits 

would be a lower bound for the de 

sired risk premium. As well, it may be 

both impractical and impracticable to 

isolate the "true" premium, i.e., the 

risk factor, from the rate differential 

that is observed. 

Some sore of ex post settling-up or extended lia 

bility schemes could be termed incentive-compatible 

as well. These schemes would expose stockholders 

and management to more of the downside risk associ 

ated with alternative investment strategies and their 

implementation would not depend on accurate actuar 

ial information. 

"Thompson (1987), p. 529. 

' The assumptions of the model include; the 

semi-strong form of the efficient-markets hypothesis 

and the dissemination of adverse information concern 

ing insured banks; the absence of transaction costs and 

indivisibilities in deposit and insurance markets; the 

absence, at the margin, of external social benefits from 

deposit insurance; the absence of supervisory forbear 

ance for insolvent banks; and the issuance of some 

uninsured deposit liabilities. Given these assump 

tions, the fair value of deposit insurance will be equiv 

alent to the market's risk premium on uninsured 

deposits. When the assumption of timely closure is 

relaxed (allowing supervisory forbearance) the mode! 

yields a lower-bound estimate for the fair value of 

deposit insurance. 

111 In addition, some uninsured depositors may feel 

that they always will have sufficient warning to with 

draw their funds prior to failure. If so, risk premiums 

on rhese deposits may not be appropriate for setting 

insurance premiums. 

28 
A Framework For Analyzing Deposit Insurance Pricing 

Integrated Systems of Public and Pri 

vate Insurance Coinsurance andRein 

surance. Some combination of public 

and private insurance has been sug 

gested as a way to overcome the short 

comings associated with purely public 

or private deposit insurance sys 

tems. It is argued that this integra 

tion of public and private sectors 

would create an insurance structure in 

which the comparative advantages of 

government and the marketplace 

would be utilized — the 

government's ability to handle exter 

nalities and the market's ability to as 

sess and price risk. In order to achieve 

this goal, the integrated system must 

be structured so that the private insur 

ers face the same risk of loss as does 

the federal insurer. Coinsurance and 

reinsurance schemes are two ap 

12,13 proaches to this integration. 

Under one such proposal (Baer 

(1985)), deposit insurance coverage 

and its pricing would be separated in 

a coinsurance scheme. Government 

would determine which classes of de 

posits are to be insured and would 

provide most of the insurance cover 

age, while private insurance compa 

nies would determine insurance 

prices. Thus, for any given bank, 

some relatively small percent of de 

posits would be insured directly by 

the private insurer and the remainder 

would be insured by the federal in 

surer. A bidding process among pri 

vate insurers would determine the 

deposit insurance premium that 

would be assessed on deposits insured 

by the public and private insurer 

alike. In order to protect the private 

insurer's solvency and, in turn, elimi 

nate insured depositor runs and re 

duce the private insurer's incentive to 

gamble on the bank's recovery, pri 

vate insurers would be required to 

fully collateralize their maximum loss 

exposure with short-term Treasury 

securities. Some terms of the private 

insurance contract, such as the risk 

premium, could be renegotiable; 

however, a non-cancellation clause 

would prohibit the private insurer 

from canceling a contract unless the 

insured bank was able to find another 

carrier. In the event that none is 

found, the bank would be declared 

insolvent and resolved by the insurer. 

More recently, the use of private 

reinsurance has been suggested as a 

way to integrate the respective abili 

ties of the public and private insurers. 

Deposit insurance pricing would be 

based on a market assessment of the 

risk that the bank poses to the public 

insurer, determined in this case by 

private reinsurers. The basic concept 

is to create a risk-sharing system 

under which a small percentage of the 

public insurer's risk that a covered 

depository institution will fail is rein 

sured with a qualified private rein 

surer. In effect, this procedure elicits 

a "market price" on which the cov 

ered bank's total premium assess 

ment can be based. An example of 

the reinsurance approach to deposit 

insurance pricing can be found in re 

cently proposed legislation, the "De 

posit Insurance Reform Act of 1991" 

S.261).14 

Thus, the integration of public and 

private insurance through a reinsur 

ance scheme would incorporate the 

private sector into the pricing and 

monitoring aspects of deposit insur 

ance and, importantly, would place an 

independent source of private capital 

at risk. The success of such a system 

could result in better pricing and ear 

lier detection of problems. As a mar 

ket-information approach to pricing 

deposit insurance, the use of reinsur 

ance is premised on the private 

reinsurers' ability to accurately assess 

and value the underlying, inherent 

risks in a timely and cost-effective 

A purely private system of deposit insurance has been advocated as an alternative to the current public system. (See, e.g.. Short and O'Driscoll (1983). Ely (1990) and Ely 

and Wallison (1990) develop a private deposit insurance system based on private-sector cross-guarantees.) Proponents argue that a competitive private system would overcome 

much of the deposit insurance mispricing associated wirh the current system. However, the existing evidence on private insurance reveals the inadequacies of a purely private 

system. Historically, private insurance systems have been unable to handle systemic problems. Notably, the state-sponsored insurance funds have been unable to protect depositors 

and, in turn, the financial system during periods nf crisis. As well, unless deposit insurance contracts are long-term in nature and include non-cancellation clauses, the problem of 

intertcmporal adverse selection would likely arise. That is, banks would choose to be insuted only during times when they expected a high probability of default, and private 

insurers would choose to insure banks only if the insurance contract included a cancellation clause. Note also with private insurance, depositors still would need to monitor the 

health of the private insurer. Thus, even in the absence of the systemic-risk problem, private insurance would generate a new set of adverse selection/moral hazard problems. 

While the term coinsurance sometimes is employed to describe risk-sharing between depositors and the deposit insurer, it is used here to describe risk-sharing between 

public and private insurers of deposits. Under a coinsurance scheme, private insurers would directly insure bank deposits. 

Reinsurance is insurance by one insurer of another insurer's risk exposure, [t commonly is used in the insurance industry to spread risk and expand capacity. That is, 

reinsurance is used to minimize the threat of systemic risk and increase the amount of insurance that an insurer is allowed, under state regulation, to write. For the purposes of 

deposit insurance, the ability of the reinsurer to accurately underwrite risk and thereby price the risk to the public insurer is emphasized rather than rhe reinsurer's risk-sharing 

capabilities. 

Introduced by Senator Dixon on January 24,1991, this reinsurance approach is designed explicitly for large banks. In the proposed legislation, covered depository institutions 

are defined as follows: (i) a bank or thrift that is pan of a bank or S&L holding company with over $1 billion in assets; (ii) a bank or thrift that is not pan of a holding company, but 

that has over $1 billion in assets; and (iii) any smaller bank that either directly or through a holding company is exercising insurance, security, real-estate, or investment powers. 

Banks that arc not covered would be subject to a simplified, partial risk-based premium system. 

Eligible reinsurers would be "qualified" insurance companies, as determined by criteria established by the public insurer subject to state insurance laws and regulations. In 

order to help ensure adequate capacity, bank holding companies would be allowed to establish insurance affiliates for reinsurance purposes. However, a reinsurer would not be 

able to offer reinsurance to any of its affiliated banks. 

In order to determine the reinsurance premium and to determine the extent of the reinsurer's access to relevant bank documents, a covered bank would negotiate directly 

with qualified private reinsurers. The proposed legislation requires that reinsurers be gran ted access to Reports of Condition and examination reports. Reinsurance coverage would 

be written for up to ten percent of the covered bank's losses in ilic event of failure. In turn, the private reinsurer would bill the FU1C for the reinsured risk. The FDIC then could 

use this price as a basis for the covered bank's entire premium, including the remaining risk that is not being reinsured. The FDIC also could adjust its part of the premium so 

that the total revenue flowing to the FDIC is sufficient to maintain the insurance fund target reserve. 

Reinsurance agreements would have a specified maximum contract length, and would include an allowance for periodic premium adjustments, subject to an appropriate cap. 

The agreements also would provide an option for the covered bank to terminate coverage with one reinsurer and obtain coverage with another reinsurer. As well, the agreements 

provide that the FDIC terminate the insured status of any covered bank that fails to obtain reinsurance within two years. 
FDIC Banking Review 

manner. However, its implementa 

tion may present practical difficulties. 

The degree to which reinsurers 

should be supervised by the public 

insurer, in addition to existing state 

insurance regulations, is another con 

cern. For example, the monitoring of 

the reinsurers1 capital adequacy 

would be necessary. Prices estab 

lished by reinsurers would be mean 

ingful only if the reinsurers are at risk 

for the full amount of their potential 

losses; with inadequate reinsurer cap 

ital this would not be the case. The 

monitoring of the capital adequacy of 

a large group of private insurers or 

reinsurers may be just as difficult as 

monitoring bank capital. 

The success of this approach de 

pends on there being sufficient capac 

ity in the reinsurance market. 

Capacity, in turn, depends on profit 

ability. Observation of the directors' 

and officers' (D&O) liability insur 

ance market during the past decade 

raises concerns regarding a sustain 

able and adequate market capac 

ity, and of a reinsurance market 

itself. Specifically, how can it be 

ensured that a reinsurance market 

wouldn't collapse as did the D&O 

liability insurance market in the mid

1980s? The possibility of a market 

collapse could generate systemic-risk 

concerns and be unacceptable from a 

public-policy perspective. How fast a 

reinsurance market will develop, its 

ultimate size, and its stability are not 

clear at this time. 

The question of adequate capacity 

also raises concerns regarding the ap 

propriateness of the public insurer's 

use of the reinsurers' prices to set its 

premiums. To ensure adequate ca 

pacity to absorb losses, it may be nec 

essary to include a cap on reinsurers' 

liability. In turn, this means the rein 

surer is not sharing pro rata in all 

losses. The premium set by the rein 

surer therefore may be too low from 

an actuarial standpoint. 

Reinsurance, as an integrated ap 

proach to deposit insurance pricing, is 

a market-based pricing method that is 

intended to create an insurance struc 

ture in which the government's ability 

to handle the risk of systemic failure, 

and the market's ability to assess and 

price risk, are combined. The success 

of this approach depends, in part, on 

the development of a sustainable, ad 

equately capitalized market for this 

particular insurance line. More funda 

mentally, its success hinges on the 

private insurers' market-price being 

an appropriate basis for a risk-based 

deposit insurance premium. Whether 

this approach is a viable method of 

pricing deposit insurance cannot be 

determined without further investi 

gation and study. 

Option Pricing. Option pricing the 

ory, which has become a standard val 

uation methodology in finance, has 

been suggested as a method of deter 

mining the value of deposit insurance 

to a bank. In application, the method 

of option pricing theory could be em 

ployed by various parties interested in 

valuing deposit insurance, such as the 

federal insurer or a private insurer or 

reinsurer. Option pricing theory is dis 

cussed here as a pricing method em 

ployed by the public insurer. 

In this application of option pricing 

theory, an analogy is drawn between 

the value of the deposit insurance 

guarantee and a put option. Options, 

as financial contracts, have been pop 

ular because they confer on the holder 

the right, but not the obligation, to 

buy or sell specified property at a 

fixed price on or until some future 

date. There are two basic types of 

option contracts. The call option gives 

the holder the right to buy an asset at 

a specified price, called the exercise 

or strike price, on or before some fu 

ture date. The put option, in contrast, 

gives the holder the right to sell an 

asset at the exercise price on or before 

some future date. 

The value of the put option at ma 

turity depends on the current value of 

the underlying asset relative to the 

contract's exercise price. If, at the 

option's expiration or maturity date, 

the asset price is greater than the ex 

ercise price, the option is not worth 

exercising and therefore the value of 

the option is zero. In this case, the put 

is termed "out-of-the-money." How 

ever, if the asset price is less than the 

exercise price, the option is termed 

"in-the-money." It will be exercised, 

because the asset can be sold at a price 

that is greater than the asset's current 

market value. The option holder will 

realize a profit equal to the difference 

between the exercise price and the 

asset price. Therefore, the value of 

the put option at maturity is equal to 

the maximum of the difference be 

tween the exercise price and the asset 

price, or zero. It follows that the value 

of an option prior to its maturity or 

expiration date will depend on the 

probability of the option being in-the

money. 

Merton (1977) was the first to 

apply option pricing theory to the 

problem of determining the value of 

deposit insurance to a bank. In partic 

ular, Merton draws an analogy be 

tween the value of the deposit 

insurance guarantee and a European 

put option, i.e., an option that can be 

exercised only at its maturity or ex 

piration dace. Merton assumes 

that banks are examined annually, in 

which case the examination date de 

termines the maturity date of the put 

option. If at the examination time the 

value of the bank's assets, less its un 

insured liabilities, are less than the 

strike or exercise price of the option, 

as measured by the value of its in 

sured deposits, the option is termed 

in-the-money and will be exercised. 

Specifically, the bank will be closed 

and the insurer will make up the dif 

ference between the value of the as 

sets and the strike price, i.e., insured 

depositors will be made whole. 17 

Romano (1989) provides an analysis and discus 

sion of problems chat occurred in the market for D&O 

liability insurance during rhe 1980s. 

American options, on the other Viand, may he 

exercised at any time up to and including the maturity 

date. 

' The concept of deposit insurance as a put option 

could be broadened to cover all deposits, both insured 

and uninsured, in the event of an insolvency or a fail 

ure. 

30 
A Framework For Analyzing Deposit Insuian.ce Pricing 

Merton argues that the deposit in 

surance guarantee is analogous to a 

put option since it allows the bank to 

sell, or put, its assets to the insurer at 

a price equal to its insured deposits. 

The deposit insurance guarantee is of 

value in that it protects insured depos 

itors from losses and thereby allows 

the bank to attract deposits at a riskfree rate. It is argued that this guaran 

tee can be priced or valued explicitly 

using a formula derived from option 

pricing theory. 

Using the option pricing frame 

work developed by Black and Scholes 

(1973), Merton derives an option pric 

ing formula for valuing deposit insur 

ance. When the option pricing 

framework is applied to the problem 

of pricing deposit insurance, the rela 

tionship between the value of the put, 

which represents the value of deposit 

insurance to the bank, and the proba 

bility of insolvency is underscored. 

Notably, changes in the capital posi 

tion of the bank lead to changes in the 

value of the deposit insurance con 

tract. For example, if the value of the 

bank's assets were to decrease rela 

tive to the value of its liabilities, the 

value of the put and deposit insurance 

to the bank's owners would increase. 

Similarly, an increase in the variability 

or volatility of the bank's return on 

assets would increase the probability 

of insolvency which would be re 

flected in an increase in the value of 

the put and deposit insurance to the 

bank's owners. 

Assuming the validity of the anal 

ogy between deposit insurance pric 

ing and the valuation of put options, 

the feasibility of using option pricing 

theory to price deposit insurance de 

pends on the ability of the insurer to 

adequately measure the return vola 

tility of bank assets in a timely man 

ner. This requires considerably more 

information than is available for most 

banks and, therefore, would be diffi 

cult to implement for most institu 

tions, 

In order to provide estimates of the 

value of deposit insurance for all 

banks, some estimate of asset returns 

and their volatility over time must be 

made. Studies that have used option 

pricing to estimate the value of de 

posit insurance have typically relied 

on changes in an institution's stock 

price over some historical period to 

estimate returns and their volatility. 

But these estimates arc based on his 

torical returns and do not necessarily 

represent the returns that an institu 

tion expects to receive based on its 

current investment decisions. To the 

extent that expected returns deviate 

from historical returns, the option 

price will be incorrect. Merton's op 

tion pricing formula assumes the se 

curity price follows a Brownian 

motion. Because bank asset values 

may not follow this pattern, the for 

mula may be inappropriate. 

As Pyle (1983) and Marcus and 

Shaked (1984) point out, small errors 

in the estimation of the value of assets 

or their volatility can have major ef 

fects on the value of the option con 

tract — that is, the insurance 

premium. Even if the volatility of 

asset values could be measured cor 

rectly, minor changes in this measure 

would have a significant effect on the 

option value of deposit insurance; this 

is particularly true of banks that are 

close to insolvency. Moreover, Ronn 

and Verma (1986) note that the esti 

mated values of the deposit insurance 

premiums are sensitive also to policy 

parameters that capture the behavior 

of regulators such as the degree of 

deterioration in a bank's assets that 

occurs before the FDIC closes the 

bank or the frequency of audits of the 

bank. Nevertheless, while the magni 

tudes of the premiums fluctuate 

greatly for small shifts in these param 

eters, the ordinal rankings of the pre 

miums are relatively robust. further 

difficulty is knowing the appropriate 

closure rule. If assumptions concern 

ing closure rules are wrong, the value 

of the put may be in substantial 18 error. 

Another practical problem with 

using the option pricing model is that 

stock-market information is available 

only for the largest banking organiza 

tions. While a proxy for stock prices 

can be estimated, it is not clear how 

well this kind of estimation technique 

would work. Moreover, where stockprice information is available, it only 

is available for the holding company 

and not for individual banks. 

Overall, the assumptions and infor 

mational requirements of the option 

pricing model present problems that 

may prevent it from being a practical 

approach to pricing deposit insurance. 

Nonmarket-Based Risk 

Assessment 

If it were not possible or when it is 

undesirable to utilize the market's as 

sessment of bank risk, the federal in 

surer would be left with the task of 

developing its own method(s) for as 

sessing risk. An important distinction 

among the nonmarket approaches is 

whether they measure risk ex ante or 

ex post. The former attempts to mea 

sure the inherent risk of banking ac 

tivities regardless of the institution's 

current performance, while the latter 

measures risk after it has materially 

affected the performance of the insti 

tution. As indicated earlier, while ex 

ante measures are conceptually pref 

erable, most proposals have used ex 

post measures due to the difficulty of 

measuring risk ex ante. 

Asset Risk Baskets. This approach 

attempts to measure risk in an ex ante 

fashion by classifying assets into 

broad categories according to their 

perceived credit risk and attaching 

risk weights to these categories. This 

is the approach taken under the riskbased capital guidelines that have 

been approved by the bank regulatory 

agencies. Under these guidelines, a 

bank is required to hold capital 

against the total risk-adjusted stock of 

assets, including off-balance-sheet as 

sets. For example, any commercial 

loan on a bank's balance sheet carries 

Brickley and James (1986) provide some empir 

ical evidence on this paint. They show [hat for the 

S&L industry during the early 1980s, the assumption 

that closure would occur at the point of insolvency 

resulted in an understatement of the option value of 

deposit insurance. Insurance would have been under

priced with this assumption. 

31 
FDIC Banking Review 

a risk weight of 100 percent. This 

means that the risk-adjusted stock of 

a bank's commercial loans would be 

equal to 100 percent, multiplied by the 

book value of its commercial loans. In 

the same way, other asset categories, 

with their own risk weights, would be 

converted from their book values to 

risk-adjusted values. 

It would be possible, although not 

necessarily desirable, to devise a riskbased premium system using the 

same approach. The measurement of 

risk under this system may be ques 

tioned on the grounds that it simply 

attaches risk weights to individual 

asset types, while ignoring the com 

position of assets within the entire 

portfolio. Furthermore, an institution 

would be able to increase the risk in 

its portfolio, without a corresponding 

increase in its risk measure, by mov 

ing to the risky end of each asset cat 

egory and by having concentrations of 

assets in particular industries or re 

gions. Such problems underscore the 

difficulty in finding acceptable ex ante 

measures of risk. 

Ratings Eased on Examination Infor 

mation. It has been suggested that in 

formation derived from the regulatory 

agencies' onsite examinations could 

be used as a basis for risk-related pre 

miums. As a result of the examination 

process, each bank is assigned an 

overall rating from 1 to 5 (5 being the 

worst) based on the bank's financial 

condition. This rating is commonly 

referred to as the CAMEL rating and 

is derived from the examiner's evalu 

ation of a bank's capital adequacy, 

asset quality, management, earnings 

and liquidity. The examination in 

formation embodied in a CAMEL rat 

ing can be considered an ex ante 

measure of risk since the examiner's 

purpose is to determine whether the 

bank is being operated in a safe-and

sound manner, and to evaluate the 

institution as a "going concern" based 

on its policies, practices and perfor 

mance. A major argument in favor of 

using information derived from exam 

inations is that it may contain inside 

information on a bank's operations 

that is not obtainable from inspection 

of the bank's financial statements. 

A major objection to using exami 

nation ratings as the sole basis for as 

signing risk premiums is that it could 

have a negative impact on the exami 

nation process. Because of the finan 

cial stakes involved with basing 

premiums on examinations, extreme 

care would need to be taken to ensure 

the application of uniform standards 

and procedures for rating banks. With 

greater reliance on rules and proce 

dures for assigning premiums, an im 

portant attribute of onsite 

examinations examiner discretion 

may be lost. Furthermore, basing 

premiums on examinations intro 

duces an adversarial relationship into 

the examination process, and the flow 

of information that normally occurs 

during an examination probably 

would be reduced. While the exami 

nation process can have an adversarial 

aspect, the purpose also is to provide 

useful information to bank manage 

ment and regulators about the sound 

ness of the bank's operation and how 

it may be improved. Increasing the 

financial stakes of the examination 

outcome could lessen the extent to 

which an examination would serve 

this purpose. 

Failure-Prediction Models, Some 

proposals for risk-related pricing 

schemes have been based on informa 

tion provided by bank-failure-prediction 

models. Failure-prediction models 

utilize historical information to deter 

mine the importance of various finan 

cial variables in predicting the success 

or failure of an institution. Those fi 

nancial variables (e.g., measures of 

nonperforming loans, earnings, capi 

tal levels, etc.) that have been consis 

tent predictors of past failures can 

then be used as a basis for a risk-re 

lated pricing system. More recently, 

these types of models have been mod 

ified to estimate each bank's "ex 

pected" insurance cost, equal to the 

bank's estimated probability of fail 

ure, multiplied by the FDIC's aver 

age cost when a bank fails. The 

expected cost then can be used as a 

basis for the insurance premium. 21 

Not surprisingly, the financial vari 

ables that prove to be most successful 

in predicting failures are primarily ex 

post measures of risk and, conse 

quently, the predictive power of these 

models declines rather rapidly when 

predicting failure much beyond a 

year. In a study by Hirschhorn (1986), 

the financial variables that did the 

best job of replicating the FDIC's 

problem-bank list included variables 

describing a bank's capital level, its 

earnings performance, and the quality 

of its loans. Using a model based on 

December 1983 Call data and limiting 

the designation of high-risk banks to 

roughly 20 percent of all banks, the 

model classified about 90 percent of 

all failures in 1984 as high-risk banks. 

However, using the same model 

about 60 percent of the failures in 

1985 were classified as high risk. 

This profile is common in failureprediction models, and illustrates 

the difficulty in detecting arid pric 23 ing risk in a timely manner. 

Adjusted Capital Approach. This ap 

proach would use a depository 

institution's capital-asset ratio, ad 

justed for some measure of asset qualThc Office of Thrift Supervision has a compa 

rable rating system for the thrifts it regulates. 

Failure-prediction models can be used for sev 

eral purposes. Many failure-prediction or problem

hank-identification models have been designed 

primarily asearly-wamingsystems. Early-warningsys

tems assist regulators in identifying potential prob 

lems and in better allocating supervisory resources to 

deal with these problems. Some failure-prediction 

models also have been designed for the purpose of 

identifying the causes of past failures, rather than for 

predicting future behavior (Pantalone and Platt 

(1987)). 

21 SeeAvecy, Hanweckand Kwasc(1985). 

22 Once ihc parameters of the failure-prediction 

model have been estimated using historical data, the 

number of institutions that will be designated as high 

risk can be varied by simply changing the probability 

of failure threshold. The threshold level is the divid 

ing line between what would be considered a highrisk bank (or alternatively a potential failure or a 

problem bank) and a low-risk bank. By lowering the 

threshold level one can increase the number of actual 

failures that are designated as high risk, but only at the 

cost of designating more nonlailutcs as high risk. 

Another factor limiting the accuracy of these 

esiimates is the fact that some banks' Call Report data 

underestimate the true extent of their problems. Per 

haps assessing banks penalties when examinations 

reveal that they have underreported problems would 

partially solve this problem. 

32 
A Framework For Analyzing Deposit Insurance Pricing 

icy and/or other performance mea

sure(s), as the basis for the 

institution's deposit insurance assess 

ment rate. One such proposal can be 

found in FOIC (1983), Chapter II. 

Capital is imporcant to the federal in 

surer because it provides a protective 

cushion against adverse changes in an 

institution's asset quality and earn 

ings. Also, che more wealth that own 

ers or stockholders have at stake in the 

long-term profitability of the bank, 

the greater is their incentive to ensure 

chat the institution is run in a safe

and-sound manner. Along with capi 

tal, the riskiness of a bank's portfolio, 

as measured by its asset quality, is an 

important aspect of the total risk that 

a bank poses to the insurance fund. It 

is this direct relationship between 

more capital and better asset quality, 

and a lower probability of failure 

which serves as the foundation for the 

adjusted capital approach. 

The adjusted capital measure at 

tempts to quantify the risk that a bank 

poses to the insurance fund. This 

measure is derived by adjusting capi 

tal for some measure of asset quality, 

and dividing by total assets. Three 

issues must be addressed in formulat 

ing an adjusted capita! ratio: (i) the 

definition of capital* (ii) the adjust 

ments) to capital; and (iii) the defini 

tion of total assets. The first issue 

concerns what should be included in 

the capital measure {i.e., common eq 

uity, allowances for loan losses, subor 

dinated debt, etc.). With regard to the 

second issue, the adjustment to capi 

tal could be based on the industry's 

historical relationship between non

performing assets and charge-offs, 

with this relationship then applied to 

each institution's current level of such 

assets. The third issue concerns 

whether to include some or all of the 

"off-balance-sheet" assets in the def 

inition of total assets. 

Ex PostSettieme?it. This proposal for 

risk-related premiums involves an ex 

post settlement for failed banks. As 

a condition for receiving federal insur 

ance, banks could be required to es 

tablish an escrow account with the 

FDIC, or bank shareholders could be 

legally subject to extended liability. 

In the event of a failure, ex post penal 

ties could be assessed depending on 

the insurer's actual loss experience. 

Extended liability would expose the 

bank's owners or stockholders to an 

extended set of negative outcomes 

resulting from its investment behav 

ior and thereby lower its expected re 

turn, rather than limiting the set of 

negative outcomes to their initial eq 

uity investment. 

A general problem with these pro 

posals is that they may result in in 

creased costs for all commercial banks 

regardless of their current risk posi 

tion. Extended liability for stockhold 

ers will increase the costs of retaining 

and attracting capital, because stock 

holders will demand additional com 

pensation for the increase in their 

potential losses should the bank fail. 

Requiring banks to maintain escrow 

accounts is equivalent to increasing 

capital requirements, while restrict 

ing the earnings potential of the 

added capital. Although these propos 

als have the potential to reduce the 

incentives toward risk-taking, they 

also have the potential to significantly 

increase banks1 cost of capital, regard 

less of the actual risk position of individ 

ual banks, and could overly restrict the 

growth of the banking industry relative 

to other financial-service providers. 

Multi-Test Risk-Based Pricing 

Schemes. Some suggestions for struc 

turing a risk-related system combine 

some of the previously mentioned ap 

proaches. For example, statistical 

models utilizing Call Report data 

could be used to estimate the risk of 

failure or the expected cost to the 

FDIC. Premiums based on these es 

timates could be double-checked by 

noting the rates paid on uninsured 

deposits or other uninsured debt, by 

comparing them to the most recent 

CAMEL rating, or by using option 

pricing techniques. Further, depend 

ing on the size of an institution, differ 

ent risk-classification techniques 

might be used in order to improve risk 

measurements. Although potentially 

more complicated, a multi-test riskbased pricing scheme could instill 

greater confidence in the regulator's 

risk assessments, and minimize in 

stances of serious mismeasurement of 

an institution's risk. 

Arguments For and Against 

Risk-Based Premiums 

The Use of Market 

Information 

Conceptually, the advantage of 

utilizing market information is that it 

represents the assessment of numer 

ous individuals who have a financial 

stake in correctly assessing bank risk. 

However, the use of certain types of 

market information may be inconsis 

tent with the manner in which the 

public insurer resolves bank failures. 

Consider, as an example, a closure 

policy that sometimes protects unin 

sured depositors against their full 

share of losses in the event of a bank 

failure. Such a policy precludes the 

use of uninsured deposit rates as an 

accurate measure of the value of the 

deposit insurance guarantee. This 

closure policy also would be inconsis 

tent with the business practices of a 

private insurer, in spite of the fact that 

under certain circumstances publicpolicy concerns regarding systemic 

risk may warrant protecting unin 

sured depositors. 

A more fundamental question is 

whether the market's assessment of 

individual banking risks is measur 

ably better than information derived 

from other sources that potentially are 

available to regulators. major reason 

why borrowers obtain loans from inSee Bensron. el a/., (1986) and Mcrrick and 

Saunders(1985). 

This problem is accentuated by the fact that 

extended liability is not a feature of Other businesses. 
FDIG Banking Reveivv 

termediaries rather than issue market 

able securities is that public informa 

tion on their economic condition and 

prospects is extremely limited and ex 

pensive. To some extent, the very 

existence of banks is explained by the 

inability of markets to act as efficient 

devices for valuing these loans. If this 

is the case, we should not expect mar 

kets to be particularly efficient at 

evaluating credit risks in individual 

banks. 

The Use ofNonmarket 

Information 

If market information is not used in 

setting insurance premiums, then it 

should be recognized that an alterna 

tive risk-related scheme amounts to a 

set of administratively determined 

prices, either explicit or implicit. The 

question then turns on how accurately 

we believe regulators can price risk. 

There have been two major criti 

cisms of basing risk-based premiums 

on ex post measures of risk. First, it is 

argued that if risk is recognized by a 

premium system only after an 

institution's asset quality has deterio 

rated, then the premium structure has 

not served its purpose of inhibiting 

risk-taking. This argument, how 

ever, fails to recognize that after-the

fact penalties may still provide some 

deterrent effect. While the best ap 

proach may be to levy a higher pre 

mium for a higher level of risk 

regardless of the assets' current per 

formance status, if a lender knows that 

a premium penalty will be charged for 

poorer asset quality, the lender will be 

forced to internalize this cost into the 

lending decisions, thereby limiting 28 excessive risk-taking. 

The second criticism of ex post 

measures of risk is that they will pe 

nalize banks when they can least af 

ford it, i.e., when they have 

encountered difficulty. A deteriora 

tion in asset quality diminishes a 

bank's earnings and puts pressure on 

its capital buffer. A premium penalty 

which is based on some measure of 

asset quality will further strain both 

earnings and capital. While this pre 

mium cost is internalized by the 

lender, the premium charge must not 

be so large as to threaten the viability 

of an otherwise sound institution. In 

addition, credit quality typically de 

clines during an economic downturn. 

Increasing premiums during an eco 

nomic downturn could further aggra 

vate banking problems. 

In sum, any use of nonperforming 

assets as a measure of risk must bal 

ance the need to impose penalties to 

deter excessive risk-taking against the 

possibility that excessive penalties 

may aggravate banking conditions 

when banks are already in a weakened 

condition. Realistically, the use of ex 

post risk measures constrains the size 

of the penalty that could be levied 

against a high-risk bank. If risk could 

be detected before a bank's perfor 

mance has deteriorated, a relatively 

heavy penalty could be levied that 

may alter its behavior without jeop 

ardizing its existence. However, levy 

ing a large penalty against a bank that 

is already performing poorly would 

probably ensure its eventual failure. 

Such a punitive policy would be anal 

ogous to an early-closure rule. For 

an undercapitalized bank, the insurer 

could levy an assessment rate that 

would be large enough to transfer the 

remaining capital from the bank into 

the insurance fund. While an earlyclosure policy could be integrated into 

a risk-based deposit insurance pre 

mium policy, the discussion of the 

issues associated with early closure is 

beyond the scope of this paper. 

It was indicated earlier that the 

current system of supervision may act 

as a system of implicit risk-based pre 

miums. To the extent that this is true, 

implicit and explicit risk-based pre 

miums are complementary in that 

they have the common purpose of af 

fecting the behavior of banks so that 

they operate in a more safe-and-sound 

manner. For example, a bank which 

has instituted policies and practices 

that have led to poor capital adequacy, 

deteriorating asset quality or exces 

sive loan concentrations, can be per 

suaded to change these practices by 

charging them higher insurance pre 

miums, or more stringent supervisory 

oversight of the bank's activities. 

While explicit and implicit riskbased pricing schemes share a com 

mon objective and could work well 

together, there are operational differ 

ences in the two approaches. One of 

the more important d ifferences is con 

sidered here. From the regulator's 

perspective, implicit pricing offers ad 

vantages in the form of greater flexi 

bility and discretion. For many of the 

current forms of implicit pricing, such 

as Memorandums of Understanding 

and enforcement actions resulting 

from the examination process, regula 

tors have considerable discretion in 

tailoring sanctions and solutions to in 

dividual cases. On the other hand, the 

institutions that are regulated some 

times view regulatory discretion as 

subjective or even arbitrary. From this 

perspective, explicit pricing rules 

would offer greater uniformity among 

banks. Therefore, a properly con 

structed combination of explicit and 

implicit risk-based pricing schemes 

would have the advantages of both, 

that is, explicit rules that would apply 

across the board while maintaining 

regulatory discretion. 

Conclusions 

Deposit insurance premiums have 

been assessed at a flat rate since the 

inception of deposit insurance in 

1933. While there is general agree 

ment that relating an insured bank's 

premium to the risk it poses to the 

insurance fund is a good idea concepOf course, this will vary from bank to bank. 

Some banks, particularly large banks, may make a 

considerable amount of loans to corporate borrowers 

for which markets generally possess a considerable 

amount of information, or some banks may have port 

folios that are weighted more hca.vi!y with maiketable 

securities or loans thai are more easily evaluated by 

markets, such as mortgages. 

This deterrence could take the form(s) of the 

lender holding higher capital levels and/or holding a 

less risky portfolio. 

An early-closure policy typically refers to the 

case in which a bank would be closed by regulators 

when iis capital stock is minimal but above zero. 

3 As stated above, an explicit premium has the 

additional objective of having riskier institutions pay 

[he insurance fund a higher fee that is more commen 

surate with the risk to which they expose the fund. 

34 
A Framework For Analyzing Deposit Insurance Pricing 

tually, the information-intensive na 

ture of the intermediation process in 

which banks specialize makes risk 

measurement a difficult task. 

In a 1983 study, Deposit Insurance in 

a Changing Environment, the FDIC 

proposed an approach for risk-based 

deposit insurance premiums that was 

based on a bank's capital position, ad 

justed for performance measures that 

could affect its capital position. The 

adjusted capital approach contained 

herein is similar to this earlier FDIC 

proposal. These capital-based ap 

proaches rely upon the most useful 

measure of a bank's risk to the insur 

ance fund capital. Overall, we be 

lieve this capital-based proposal to be 

[he most promising approach that is 

currently available for a risk-based 

premium system. 

A risk-based deposit insurance 

premium system is not a panacea for 

the problems facing the banking sys 

tem and it should serve as a comple 

ment to, not a substitute for, vigilant 

supervision and adequate capital. 

Nevertheless, a risk-based premium 

system would mitigate the subsidy 

provided to high-risk banks that exists 

under the current flat-rate premium 

system, and it would give all insured 

depository institutions a financial in 

centive to control risks. 

35 
FDIC Banking Review 

SELECTED BIBLIOGRAPHY 

Avery, Robert, Gerald A. Hanweck, and Myron L. Kwast. "An Analysis of Risk-Based Deposit Insurance 

for Commercial Banks." In Federal Reserve Bank of Chicago Proceedings of a Conference on Bank 

Structure and Competition, pp. 217-50. Chicago: n.p., 1985. 

Baer, Herbert. "Private Prices, Public Insurance: The Pricing of Federal Deposit Insurance." 

Federal Reserve Bank of Chicago Economic Perspectives (September/October 1985):45-57. 

Benston, George J., Robert A. Eisenbeis, Paul M. Horvitz, Edward J, Kane, and George G. Kaufman. 

Perspectives on Safe and Sound Banting: Past, Present, and Future. Cambridge, MA: MIT Press, 1986. 

Bierwag, Gerald O. Duration Analysis: Managing Interest Rate Risk. Cambridge, MA: 

Ballinger Publishing Company, 1987. 

Black, F., and M. Schofes. "The Pricing of Options and Corporate Liabilities." 

Journal of'Political Economy 81 (May 1973):637-59. 

Brickley, James A.f and Christopher M. James. "Access to Deposit Insurance, Insolvency Rules and 

the Stock Returns of Financial Institutions." Journal ofFinancial Economics 16 (1986):345-7I. 

Ely, Bert. "Making Deposit Insurance Safe Through 100% Cross-Guarantees." (Preliminary Draft.) 

Alexandria, VA: n.p., 1990. 

Ely, Bert, and Peter J. Wallison. "The Supplementary Deposit Protection System: A Proposal for 

Deposit Insurance Reform." (Unpublished Draft.) Alexandria, VA and Washington, DC: n.p., 1990. 

Federal Deposit Insurance Corporation. A Study of the Desirability and Feasibility ofa Risk-Based Deposit 

Insurance Premium System. Washington, DC: Federal Deposit Insurance Corporation, 1990. 

Federal Deposit Insurance Corporation. Deposit Insurancefor the Nineties: Meeting the Challenge. 

(Unpublished Draft.) Washington, DC: Federal Deposit Insurance Corporation, 1989. 

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

Federal Deposit Insurance Corporation, 1983. 

Federal Deposit Insurance Corporation Assessment Act of 1990. Pub. L. No. 101-508, 104 Stat. 1388. 

Federal Home Loan Bank Board. Agenda for Reform: A Report on Deposit Insurance Reform. 

Washington, DC: Federal Home Loan Bank Board, March 1983. 

Financial Institutions Reform, Recovery, and Enforcement Act of 1989. Pub. L. No. 101-73, 103 

Stat. 183. 

French, George E. "Measuring the Interest-Rate Exposure of Financial Intermediaries." 

FDIC Banking Review (Fall 1988): 14-27. 

Furlong, Frederick T. "Changes in Bank Risk." Federal Reserve Bank of San Francisco 

Weekly Letter, 25 March 1988. 

Furlong, Frederick T., and Michael C. Keeley. "Bank Capital Regulation and Asset Risk." 

Federal Reserve Bank of San Francisco Economic Review (Spring 1987):20-40. 

Goodhart, C.A.E. "Why Do Banks Need a Central Bank?7' Oxford Economic Papers 39 (l987):75-89. 

Goodman, Laurie S., and S. Shaffer. "The Economics of Deposit Insurance: Critical Evaluation of 

Proposed Reforms." Yale Journal ofRegulation 2 (1984):145-62. 

Hirschhom, Eric. "Developing a Proposal for Risk-Related Deposit Insurance." Federal Deposit 

Insurance Corporation Banking and Economic Review 4 (September/October 1986):3-10. 

Horvitz, Paul. "The Case Against Risk-Related Deposit Insurance Premiums." 

Housing Finance Review 2 {July 1983):253-63. 

Maisel, Sherman J. Capital Adequacy in Commercial Banks. Chicago: The University of 

Chicago Press, 1981. 

Marcus, Alan J., and Israel Shaked. "The Valuation of FDIC Deposit Insurance Using Option-Pricing 

Estimates." Journal ofMoney, Credit and Banking 16, 4 (November 1984, Part l):446-60. 

Merrick, John J., and Anthony Saunders. "Bank Regulation and Monetary Policy. " 

Journal ofMoney, Credit and Banking 17 (November 1985, Part 2):691-717. 

Merton, Robert C. "An Analytic Derivation of the Cost of Deposit Insurance and Loan Guarantees: An 

Application of Modern Option Pricing Theory." Journal of Banking and Finance 1 (June 1977):3-11. 

Pantalone, C. C, and M. B. Platt. "Predicting Commercial Bank Failure Since Deregulation." 

Federal Reserve Bank of Boston New England Economic Review {July/August 1987):37-47. 

36 
A Framework For Analyzing Deposit Insurance Pricing 

Peltzman, Sam. "The Costs of Competition: An Appraisal of the Hunt Commission Report." 

Journal of Money, Credit and BankingA (November 1972): 100-4. 

Pyle, David H. "Pricing Deposit Insurance: The Effects of Mismanagement.7' Working Paper, Eederal 

Reserve Bank of San Francisco, October 1983. 

Romano, Roberta. "What Went Wrong with Directors' and Officers' Liability Insurance?" 

Delaware Journal of Corporate Law 14 (1989): 1-33. 

Ronn, Ehud I., and Avinash K. Verma. "Pricing Risk-Adjusted Deposit Insurance: An Option Based 

Model." Journal of Finance A\ (September I986):871-95. 

Short, Eugenie D., and Gerald P. O'Driscoll, Jr. "Deregulation and Deposit Insurance." Federal 

Reserve Bank of Dallas Economic Review (September 1983): 11-22. 

Thomson, James B. "The Use of Market Information in Pricing Deposit Insurance." 

Journal ofMoney, Credit and Banking 19 (November 19S7):528-37. 

U.S. Congress. Senate. Deposit Insurance Reform Act of 1991. 102si Cong., 1st sess., S.261. 

January 24, 1991. 

U.S. Department of the Treasury. Interagency Study. Modernizing the Financial System: Recommendations 

for Safer, More Competitive Banks. Washington. DC: U.S. Department of the Treasury, 

February 1991. 

U.S. Department of the Treason'. The Working Group of the Cabinet Council on Economic Affairs. 

Recommendations for Change in the Federal Deposit Insurance System. Washington, DC: 

U.S. Department of the Treasury, January I98.S. 

U.S. General Accounting Office. Staff Study. Deposit Insurance: Analysis of Reform Proposals. 

Washington, DC: U.S. General Accounting Office, September 1986. 

37 
FDIC Banking Review 

Recent Developments 

Affecting Depository 

Institutions 

by Benjamin B. Christopher* 

Regulatory Agency Actions 

Federal Deposit 

Insurance Corporation 

Capital Maintenance Rules 

The FDIC adopted final amend 

ments, effective June 19, 1991, to its 

capital maintenance regulations, de 

leting references to "primary capital" 

and "secondary capital." In place of 

these deleted terms, "Tier 1 capital" 

and "Tier 2 capital" are utilized. 

The final amendments changed 

the level of capital (from three per 

cent to two percent) at which an in 

sured depository institution is 

deemed to be in an unsafe or unsound 

condition under Section 8(a} of the 

FDI Act. The "unsafe or unsound 

condition" test is now based solely on 

Tier 1 capital. 

Insured institutions may no longer 

include allowances for loan and lease 

losses in their leverage capital calcula 

tions, and references to those allow 

ances are deleted. FR, 5/20191, p. Z3010. 

Capital Order Upheld 

In respect to a capital directive is 

sued by the FDIC, a U.S. court of 

appeals in New Orleans ruled that a 

bank is not entitled to an agency hear 

ing or court review because issuance 

of the directive is within FDIC discre 

tion as a matter of law {FDIC v. Bank 

of Coushatta, 5/13/91). The court re 

jected the bank's argument that the 

lack of review by the agency or courts 

violates the Administrative Procedure 

Act, or due process guarantees under 

the Fifth Amendment. BBR, 5120/91, 

p. 918. 

Insider Transactions 

The FDIC proposed a new part to 

its regulations that would: 1} provide 

that business dealings (other than ex 

tensions of credit) between an insured 

nonmember bank and its directors, 

executive officers, principal share 

holders, and their related interests 

("bank insiders") must meet an arm's

length standard, 2) require that cov 

ered business dealings exceeding a 

certain aggregate amount be ap 

proved by the bank's board of direc 

tors in advance, 3) require bank 

insiders to disclose their conflicts of 

interest, 4) provide for certain 

recordkeeping requirements, 5) re 

quire the bank's board of directors to 

adopt written guidelines governing 

covered business dealings, and 6) pro 

hibit insured nonmember banks from 

investing in real estate in which any 

bank insider has an equity interest. 

FIL-43-91, FDIC,8/15191; FR,8/8/91,p.37673. 

Proposed Limits on 

Golden Parachutes 

The FDIC issued a proposal in 

tended to prevent insured banks and 

savings associations from entering 

into excessive or inappropriate com 

pensation arrangements with employ 

ees and directors, among them certain 

''golden parachute" payments. The 

proposal is aimed at stopping abuses 

when: 1) a troubled institution makes 

a large cash payment to an executive 

officer when that individual resigns, 

and 2) an institution either reimburses 

or pays "up front" for liabilities or 

legal expenses which an officer, direc 

tor or employee incurs in connection 

with an administrative or civil en 

forcement action. Anti-fraud legisla 

tion enacted by Congress last year 

authorized the FDIC to prohibit or 

limit "any golden parachute payment 

or indemnification payment." 

The proposal generally would pro 

hibit golden parachute arrangements 

by an institution that is insolvent, in 

conservatorship or receivership, rated 

"4" or "5" on the interagency fivc

"Scnjamin Br Christopher is a financial economic! 

in ihc FDlC's Division of Research and Statistics. 

RcfeTCnec sources; Amerienn Banker (AB). Will! 

Street Journal (WSJ); BNA's Banking Report (BBR); 

FederalRegister {VR); Commerce Clearing House Inc.. 

Electronic Legislative Search System (ELLS). 

3c 
Recent Developments 

point rating scale for financial sound 

ness, or that is subject to a proceeding 

to terminate deposit insurance. Ex 

ceptions would be permitted if a 

golden parachute were used to: 1) at 

tract a new manager to improve the 

institution's condition, provided the 

institution obtains the written con 

sent of its primary federal regulator 

and the FDIC; 2) provide financial 

assistance to staff losing their jobs in 

a cost-cutting move, and in this con 

nection, the proposal would limit the 

maximum severance benefit and re 

quire 30 days' prior notice to the pri 

mary regulator and the FDIC before 

paying a senior executive; and 3) sup 

plement traditional retirement bene 

fits for senior executive officers 

through certain deferred compensa 

tion plans. 

The proposal also would ban any 

insured institution from making in 

demnification payments to an em 

ployee prior to a final order clearing 

the individual of any charges, unless 

the institution's board satisfies six cri 

teria indicating that the payment or 

reimbursement is reasonable. 

The FDIG is particularly inter 

ested in comments on whether the 

plan would appropriately balance the 

needs of the insurance funds with the 

needs of institutions to attract and re 

tain qualified directors and managers. 

PR-14J-9J, FDIC, 9124191; FR, 1017, p. 50529. 

Appraisals 

The FDIC issued a proposal, sim 

ilar to those being developed by other 

federal bank regulators and the RTC, 

that would decrease the number of 

transactions requiring an appraisal 

prepared by a certified or licensed ap 

praiser, thereby reducing the costs of 

these transactions. If adopted, the 

proposed amendments would: 1) raise 

the threshold to $100,000 from 

$50,000 for transactions covered by 

the regulation, 2) permit the use of 

appraisals made for loans insured or 

guaranteed by an agency of the fed 

eral government, and 3) clarify that 

the appraisal requirements do not 

apply to mineral rights, timber rights 

or growing crops. 

Transactions below the $100,000 

threshold would remain subject to ac 

tive federal supervision. Any transac 

tion not covered by the regulation 

would be supported by an appropriate 

estimate of value prepared in accor 

dance with the FDIC guidelines for 

Real Estate Appraisal Policies and 

Review Procedures. fil-48-91, FDIC, 

9/20/9/; FR, 9/17, p. 47035. 

Enforcement Actions 

Made Public 

The FDIC released a list of orders 

of administrative enforcement actions 

taken against banks and individuals in 

August 1991. A total of 46 final orders 

were processed, among which were 15 

cease-and-desist orders, nine Call Re 

port penalties, and eight removal and 

prohibition orders. 

The Financial Institutions Re 

form, Recovery, and Enforcement 

Act of 1989 (FIRREA) requires fed 

eral banking agencies to make avail 

able to the public any final 

enforcement orders issued, modified 

or terminated subsequent to 

FIRREA's enactment on August 9, 

1989. In January 1990, the FDIC 

made public a list of orders issued up 

to that time, and subsequently has 

released the list each month. 

Generally, orders of enforcement 

actions are issued with the intent of 

putting a stop to unsafe or unsound 

practices. The orders are terminated 

when the appropriate corrective ac 

tion is taken or the institution closes. 

If an individual or institution does not 

consent to such orders, a full adminis 

trative hearing is held. PR-i22-91, FDIC, 

8/22/91 ;PR-124, 9/27. 

Disclosure ofCRA 

Examinations 

The FDIC adopted a final rule, 

making permanent a temporary rule 

effective July 1, 1990, to implement 

changes in the Community Reinvest 

ment Act (CRA) contained in 

FIRREA relating to the disclosure of 

CRA evaluations. 

A financial institution examined for 

compliance with the CRA on or after 

July 1, 1990 is required to: 1) make its 

most current CRA performance evalu 

ation, but not the examination report, 

available to the public within 30 busi 

ness days of its receipt from the 

FDIC, 2) place the evaluation, at a 

minimum, in the institution's CRA 

public file located at the head office 

and a designated office in each local 

community, 3) notify the public, at 

each deposit facility, of the availabil 

ity of the evaluation within 30 busi 

ness days of receipt of the first 

evaluation, and 4) provide a copy of its 

current evaluation to the public upon 

request. Fll.-39-91,FDIC, 7/25/91;FR, 6/12, 

p. 26903. 

Increase in Assessment 

Rate Adopted 

The FDIC increased the assess 

ment rate to be paid by members of 

the Bank Insurance Fund (BIF) from 

19.5 cents to 23.0 cents per $100 of 

deposits, applicable to the assessment 

due in the second halfofcalendaryear 

1991, and to subsequent assessments. 

The new rate is being set in compli 

ance with FIRREA, which requires 

the FDIC to increase the BIF's re 

serves to $1.25 per $100 of insured 

deposits within a reasonable time pe 

riod. PR-65-91, FDIC, 4/30; FR, 5/7, p. 21064. 

Midyear Financial Results 

The BIF amounted to $4.5 billion 

as of June 30, 1991, based on prelimi 

nary financial statements. 

A revised method, which was 

agreed to in concept by the U.S. Gen 

eral Accounting Office (GAO), was 

used to determine the BIF's contin 

gent liabilities for losses from future 

bank failures. 

The FDIC, in accordance with 

generally accepted accounting princi 

ples (GAAP), recognizes as a liability 

estimated losses from banks that have 

not failed but are likely to close. Pre 

liminary figures for year-end 1990 

showed the BIF had declined 37 per 

cent from the previous year, to $8.4 

billion, based in part on a $3.4 billion 

39 
FDIC Banking Review 

contingent loss liability related to 

bank failures that either occurred in 

early 1991 or were expected to occur 

during the year. However, after audit 

review by the GAO, che amounts 

were adjusted to reflect a larger loss 

liability for expected 1991 failures. 

Under the new methodology, in 

general, contingent losses will be rec 

ognized for troubled but still operat 

ing institutions that meet one of two 

conditions: 1) that the institution be 

"equity insolvent," meaning that its 

equity under GAAP was zero or less, 

based on the most recent financial 

report filed with bank regulators; or 

2) that the institution is not techni 

cally equity insolvent but its earnings 

trend and other financial attributes 

indicate that the institution is, "in 

substance," equity insolvent. 

Using this methodology, contin 

gent losses at year-end 1990 were $7.7 

billion — about $4.3 billion above 

what the FDIC originally deter 

mined, and the BIF balance was $4.0 

billion. The preliminary BIF balance 

at midyear 1991 was $4.5 billion. 

PR-I23-9I,FDIC,8/23. 

April Survey Finds 

Improvement in Real 

Estate Markets 

Respondents to the 

ofRealEslate Trends, polled during the 

first three weeks of April, believed 

that real estate markets, on balance, 

have strengthened in the past six 

months. The national composite 

index of real estate trends stood at 61. 

Values of the index above 50 mean 

that more respondents believe condi 

tions are improving than declining, 

while values below 50 mean more are 

seeing a decline than an improve 

ment. For the first of the FDIC's 

planned semiannual surveys of real 

estate market trends, nearly 500 se 

nior examiners and liquidators from 

the federal bank and thrift supervi 

sory agencies and the RTC were in 

terviewed. 

The strongest regional responses 

that market conditions are improving 

came from the West and South, while 

in the Northeast the negative re 

sponses outweighed positive ones. 

Respondents from all regions were 

less favorable about conditions in 

commercial real estate. 

More than half of all the respon 

dents said banks have become less 

active lenders forconstruction of com 

mercial properties, and only nine per 

cent saw more activity. For residential 

construction lending, slightly over 

one-third believed banks had cut 

back, while 22 percent reported that 

banks were more active. Survey of Real 

Estate Trends, FDIC, April 1991. 

The next Survey will be based on 

information being collected for the 

period of mid-October. 

Resolutions ofBank and 

Thrift Failures in 

New Hampshire 

The FDIC approved the assump 

tion of deposits and certain other lia 

bilities of seven New Hampshire 

banks closed by their respective char 

tering authorities. It was determined 

that a deposit assumption would be 

less costly to the insurance fund than 

a payout of only insured deposits. 

Four commercial banks closed are 

to reopen as branches of the $1.25 

billion-deposit First NH Bank, Con 

cord, and three savings banks closed 

are to reopen as branches of New 

Dartmouth Bank, a newly chartered 

bank to be headquartered in Man 

chester. The estimated cost to the 

BIF from the four commercial bank 

failures is approximately $342 million, 

and from the three savings bank fail 

ures, approximately $624 million. 

Chairman L. William Seidman said 

"an infusion of public and private sec 

tor funds .. [in the transactions].. will 

result in a New Hampshire banking 

system better positioned to meet the 

credit needs of the area's businesses 

and consumers, and better able to 

weather future economic storms." 

The transactions are unusual for 

several reasons. First, instead of mar 

keting the failed banks individually to 

potential purchasers, the FDIC pack 

aged the four commercial banks as 

one franchise for sale and placed the 

three savings banks into another fran 

chise for sale. Other noteworthy ele 

ments of the transactions include: 

* A "shared equity" feature 

whereby the FDIC will tempo 

rarily infuse cash into First NH 

Bank and Dartmouth Bank by 

agreeing to a short-term pur 

chase of perpetual preferred 

stock of the two institutions. 

* A "loss sharing" component 

whereby the acquiring bank will 

retain ownership of the failed 

banks' problem residential 

mortgages and other consumer 

loans, and will be reimbursed by 

the FDIC for most, but not all, 

of the future losses. 

* The establishment of a "sepa 

rate asset pool" for the failed 

banks' classified assets, repos 

sessed real estate, subsidiaries 

and unwanted bank premises. 

This pool will be owned by the 

FDIC and managed by a third 

party under FDIC supervision. 

PR-150-9I, FDIC, I0I10I9I. 

Public Hearings on Possible 

Terminations ofInsurance 

The FDIC announced the sched 

uling of separate public hearings to be 

held before administrative law judges 

in Texas to determine whether the 

agency should terminate the insured 

status of three unaffiliated Texas 

banks: First State Bank of Marlin; 

Gladewater National Bank, Gladewa

ter; and First National Bank of Day 

ton, Dayton. Federal banking 

agencies are required under The 

Comprehensive Thrift and Bank 

Fraud Prosecution and Taxpayer Re 

covery Act of 1990 to open to the 

public any such proceedings held 

after November 30, 1990. PR-149-91, 

FDIC, 10/8/91. 

Restrictions on S&Ls 

Converting to Banks 

The FDIC adopted a rule, effec 

tive June 5, 1991, under which any 

federally insured savings and loan as

40 
Recent Developments 

sociation (S&L) that converts to a 

state-chartered bank, whether it is a 

savings bank, commercial bank or 

some other form of bank, and retains 

its membership in the Savings Associ 

ation Insurance Fund (SAIF) will 

continue to be subject to restrictions 

and notice requirements imposed on 

S&Ls by FIRREA. In addition to 

FIRREA's prohibition on junk bond 

investments, these restrictions in 

clude limits on loans to one borrower 

and prohibitions on loans to affiliates 

engaging in certain high-risk activi 

ties. The law also requires prior notice 

to the FDIC before establishing sub 

sidiaries or conducting a new activity 

in an existing subsidiary. 

SAIF member national banks are 

not covered by this rulemaking be 

cause these institutions already are 

subject to rules that, with minor ex 

ceptions, are comparable to or tougher 

than the limits in the FDIG rule. 

PR-66-9I, FDIC, 4130/91; FR, 5/6, p. 20521. 

SAIF-to-BIF Fees 

For deposits being transferred 

from the SAIF to the BIF, beginning 

July 1, 1991 the entrance fee will be 

based on the most recent end-of

quarter ratio of the net worth of the 

BIF, unaudited, to aggregate domes 

tic deposits in BIF-insured banks. 

Previously, the entrance fee was cal 

culated from year-end deposits and 

audited FDIG statements. The en 

trance fee would be 28 basis points 

(.0028) based on March 31,1991 data. 

The BIF-to-SAIF conversion fee 

continues to be one basis point 

(.0001). FR, 711191,p. 29893. 

Fair Housing 

The FDIG proposed to amend its 

regulations to achieve conformity 

with the Home Mortgage Disclosure 

Act (HMDA), as amended by 

FIRREA, and as implemented by 

Regulation C of the Federal Reserve 

Board which requires certain insured 

state nonmember banks {among oth 

ers) to maintain information on home 

loan applications in a register format. 

The FDIC requires the reporting of 

similar information on its loan logsheets. The proposal would eliminate 

duplicative reporting, enabling the 

banks to maintain a HMDA register 

in the Reg. format by recording data 

as to race or national origin, sex, and 

income for all applicants, and entering 

all required information on the regis 

ter within 30 calendar days after final 

disposition of the loan application. 

Another advantage under the pro 

posal is that the HMDA register for 

mat provides more detailed data in 

some respects. FR, 5/13191,p. 21335. 

Security Devices 

and Procedures 

The FDIC revised its require 

ments for minimum security devices 

and procedures, largely to give insti 

tutions additional flexibility to select 

appropriate security devices, espe 

cially in light of rapidly changing 

technology. The new rules are effec 

tive May 3, 1991. 

Each bank's board of directors 

must designate a security officer to 

administer a written security program, 

which must, at a minimum, provide 

for specific devices for cash security, 

vault-area lighting, an alarm system, 

and certain locks. Several specific re 

quirements for security devices in the 

existing rule are eliminated, and the 

selection of others is left to the discre 

tion of the security officer and the 

bank's board of directors. The current 

requirement for an annual report on 

security compliance to the FDIC is 

eliminated. Instead, the revised rule 

requires the security officer to report 

to the bank's board of directors on the 

operation and effectiveness of the 

program at least annually. FJL-1S-91, 

FDIC, 4/29191. 

Agencies Adopt Uniform 

Rules of Practice 

and Procedure 

As required under Section 916 of 

FIRREA, the FDIC, the Office of the 

Comptroller of the Currency (OCC), 

the Federal Reserve Board (FRB), 

the Office of Thrift Supervision 

(OTS), and the National Credit 

Union Administration (NCIJA) have 

each adopted a final rule intended to 

standardize procedures for formal ad 

ministrative actions and to facilitate 

administrative practice before the 

agencies. FR,818/91,p.37762,819,pp.37968, 

38024,38048; 8112, p. 38302. 

Report ofD&O Liability 

Insurance 

A report was released, pursuant to 

a requirement of FIRREA, that the 

FDIC, together with the Secretary of 

the Treasury and the Attorney Gen 

eral, conduct a comprehensive study 

of directors' and officers' liability in 

surance and depository institution 

bonds, and the availability of such in 

surance for directors and officers of 

insured depository institutions. 

The study includes, as mandated: 

1) consideration of state laws limiting 

liability for directors and officers; 

2) the effect of contractual provisions 

limiting insurance coverage when an 

institution is placed in receivership or 

conservatorship; 3) provisions limit 

ing coverage when a claim is made by 

the FDIC; and 4) provisions limiting 

claims made by one insured against 

another insured. Also, it considers the 

need for such insurance or bonds and 

the effect any change in any of the 

above conditions or terms may have 

on the future availability of such in 

surance, and the ability of depository 

institutions to attract qualified offi 

cers and directors. Report on Directors'and 

Officers' Liability Insurance andDepository Institu 

tions Bond Pursuant to Section 220(b)(3) of 

FIRREA, September 13,1991. 

Credit Standards Advisory 

Committee Meeting 

The bank and thrift regulatory 

agencies issued a notice of a public 

meeting of the Credit Standards Ad 

visory Committee, to be held in late 

October. 

The Committee, which was estab 

lished by Section 1205 of FIRREA, 

will review, monitor, and make rec 

ommendations concerning the credit 

standards and lending practices of in 

sured depository institutions and the 

supervision of such standards and 

41 
FDIG Banking Review 

practices by the federal financial insti 

tution regulators. At its first meeting 

in July 1991, the Committee formed 

three working groups to look at prac 

tices and policies relating to consumer 

loans, commercial and industrial 

loans, and real-estate loans. 

FRJ0IUf9i,p.5I392. 

Suit Against Accounting Firm 

Is Dismissed 

federal judge in Dallas dismissed 

a suit filed by the FDIG against Ernst 

Young for audits prepared of West 

ern Savings Association, which failed 

in 1986. The suit charged that West 

ern suffered losses because its board 

relied on faulty audits prepared in 

1984 and 1985 by Ernst & Young's 

predecessor firm, Arthur Young Co. 

The court found that the FDIC had 

failed to show that faulty audits had 

caused losses at the institution. WSJ, 

1012191, p. B5; BBR, 10171 p. 571. 

Resolution Trust Corporation 

and Oversight Board 

Negotiated Sales for 

Commercial Assets 

The RTC described two basic 

marketing structures it may utilize for 

negotiating sales of large pools of 

hard-to-sell assets. One approach in 

volves soliciting investor interest on 

structured pools of RTC commercial 

assets. In practice, the RTC would 

advertise base-line characteristics of 

the pool, such as the size of the port 

folio and the type of assets. Based on 

investor response, the RTC then 

would select the best proposal and 

negotiate a final sale. In the alterna 

tive approach, the RTC would con 

struct a portfolio containing widely 

marketed assets, and solicit offers for 

the portfolio. The RTC then would 

select the best offer and negotiate 

final sales terms. 

As part of both transactions, invest 

ors would be prequalified as purchas 

ers by a third party who would 

determine their financial capacity and 

capabilities to manage and enhance 

the values of the assets being sold. 

Investors would have the opportunity 

to make cash offers or request any 

type of financing available from the 

RTC, including conventional or cash 

flow financing. PR-i74-9!,5/2i,RTC. 

The RTC adopted a policy state 

ment, effective May 21, 1991, en 

abling the agency to negotiate sales of 

$100 million or more of hard-to-scll 

assets under either of two conditions: 

1) the specific asset pool, or criteria for 

identifying an asset pool, has been 

advertised and proposals have been 

widely solicited, 2) the present-value 

sales price exceeds the sum of the 

minimum acceptable sale prices for 

the individual assets. FR, 7/10/91, 

p. 31451. 

In a pilot program, the RTC will 

competitively solicit and select pur 

chase offers for portfolios of qualified 

assets, with total authorized sales of 

up to $8.0 billion (net present value of 

expected proceeds). 

RTC financing may be offered to 

qualified purchasers of these portfo 

lios, and such financing may include 

performance-based cash-flow obliga 

tions, in addition to other types of 

financing which have been author 

ized by the Oversight Board. The 

RTC will reserve a position to share 

in any upside asset appreciation upon 

sale or refinancing, where appropri 

ate. Any RTC financing provided 

under this pilot will be counted to 

ward the current $7 billion seller-fi 

nancing ceiling established by the 

Oversight Board. "PolicyStatement: Market 

ing ofAsset Portfolios," DRAFT, RTC, 9/10191. 

Policy on Sale ofReal Estate 

The RTC liberalized its real-estate 

pricing policy to provide a more flex 

ible approach for adjusting prices 

quickly in response to local market 

conditions, while ensuring that RTC 

property sells at true market value. 

Formerly, real-estate prices could 

be reduced by only 20 percent if a sale 

did not occur after nine months. The 

practical effect of this policy has been 

that offers lower than 80 percent of 

appraised value could not be accepted 

until a new appraisal was ordered, 

supporting the lower price. Under the 

new policy the RTC would not have 

to incur the expense of ordering a new 

appraisal or delay acceptance of an 

offer until a new appraisal is com 

pleted. The RTC will rely on quali 

fied real-estate professionals to 

ensure that properties are adequately 

exposed to the marketplace and sold 

at market values. PR-i 13-91, RTC,3I26/91. 

Expedited Contracting 

Procedures for Auctions of 

Small Assets 

The RTC adopted new standard 

ized, competitive contracting proce 

dures, designed to speed up the 

process of selecting locally- based 

auctioneers to sell some of the 

agency's assets. The new procedures 

will apply to auctions of real-estate 

properties that are expected to sell at 

$1.5 million or less and furniture, 

fixtures and equipment valued at 

$500,000 or less. Elements of the new 

procedures include simplified pro 

posal requirements; streamlined pro 

posal review by field program and 

contracting personnel; and execution 

of an abbreviated, pre-approved stan 

dard agreement to be signed by con 

tracting personnel in the field. 

PR-167-91,PRT,5I16. 

Restrictions on Certain 

Persons from Buying 

RTC Assets 

The RTC has approved a proposed 

regulation wherein the RTC will not 

sell any asset of an association to an 

individual or entity whose key offi

cial(s) participated in transactions re 

sulting in a substantial loss to that 

association, has been removed or 

barred by a federal regulatory agency 

from participating in the association's 

affairs, or has misused the 

association's funds. In addition, the 

RTC will not provide seller financing 

to a person or entity who defaulted on 

obligations of more than $1 million to 

a savings association and had engaged 

in fraud in connection with those ob 

ligations. A cash sale in this circum 

stance, however, would not be 

prohibited. 

42 
Recent Developments 

The restrictions would be lifted if, 

in the course of an asset's sale or trans 

fer, the purchaser or transferee's obli 

gations to the savings association or to 

the RTC were resolved or settled. 

The RTC also intends to limit the 

possi ble retroactive effect of this pro 

posal. Prospective asset purchasers 

will be required to self-certify that 

they are not barred from purchasing 

assets. PR-437-91, RTC, 1012191; FR, 1019, 

p. 50829. 

Collateralized Bond 

Obligation Transaction 

Is Completed 

The RTC completed its first col 

lateralized bond obligation (GBO) 

transaction, this involving 25 institu 

tional investors worldwide in a private 

placement sale. The RTC recovered 

$194.5 million from the transaction. 

High-yield bonds from portfolios of 

15 RTC conservatorship and receiv 

ership institutions serve as the collat 

eral for the CBO. The portfolios of 

high-yield bonds, with a total par 

value of$253 million, include 62 bond 

issues from companies in 27 different 

industries. 

The RTC created a unique struc 

ture for its first CBO in order to min 

imize risk. If the quality of any of the 

high-yield bonds backing the CBO 

declines significantly, the bonds will 

be sold and the proceeds will be used 

to pay down the CBO notes. Any sur 

plus cash flows from the collateral not 

required to pay principal and interest 

on the CBO notes will be returned to 

the RTC. News Release, RTC, 1018191. 

Offerings of Mortgage-Backed 

Securities 

The RTC scheduled fourofferings 

of mortgage pass-through securities 

totalling about $2 billion, including 

the first offering led by a minorityowned underwriting firm. The mort 

gages backing the offerings are 

performing and generally do not con 

form to Fannie Mae's or Freddie 

Mac's standatds. By sccuritizing non

conforming mortgages, the RTC can 

produce a more marketable asset, sig 

nificantly improving cash recoveries 

for the taxpayer. 

In April 1991, the RTC filed a shelf 

registration statement with the Secu 

rities and Exchange Commission for 

the sale of $4 billion of mortgage passthrough securities backed by mort 

gages from RTC conservatorship and 

receivership institutions. In Septem 

ber, the RTC filed for the sale of an 

additional $10 billion of such securi 

ties. There have been 12 previous 

takedowns from the RTC's $14 bil 

lion shelf totalling about $5.1 billion. 

PR-45I-91, RTC, 10/15/91. 

Disclosure of Asset Sales 

Information 

The RTC expanded its policy on 

public disclosure of asset sales infor 

mation. The information to be dis 

closed following the settlement of all 

sales transactions will consist of the 

asset sales price, the purchaser's iden 

tity, the losing bidders' identities and 

the losing bid amounts. The losing 

bidders' identities, however, will not 

be linked to their bid amounts, with 

an exception concerning information 

on securities sales. This information 

will be disclosed thirty days after set 

tlement. This policy will affect only 

those securities transactions occurring 

after the date of publication of this 

notice. FR, 9/27/91,p. 4921. 

Contractor Ethics 

The RTC adopted procedures to 

provide for the suspension and/or ex 

clusion of contractors from RTC con 

tracting and/or the recision of RTC 

contracts to ensure ethical integrity 

and full compliance with all applica 

ble statutory requirements. The 

RTC's notice serves to alert all cur 

rent and prospective contractors that 

the procedures are available for in 

spection and copying by the public. 

FR, 4/25/91, p. 19130. 

Oversight Board's Minority 

and Women Contracting 

Outreach Program 

The Oversight Board (OB) issued 

a final rule establishing an outreach 

program, as required by FIRREA, for 

maximizing the participation of mi 

norities and women, and firms owned 

by them, in the agency's contracts. 

The OB set up a minority and women 

outreach program for the Board's con 

tracting in July 1990, and issued a 

proposed rule in June 1991. 

The final rule, effective October 7, 

1991, includes in part: 1) identifica 

tion of minority- and women-owned 

firms capable of providing goods and 

services to the OB; 2) certification of 

identified firms; and 3) guidelines for 

the solicitation and award of contracts 

that promote the participation of mi 

nority- and women-owned firms in 

OB contracting and the performance 

of contracts. 

The OB's outreach program for its 

contracting activities does not apply 

to the RTC, which is required by 

FIRREA to establish its own separate 

outreach program (see below). FR, 

9/6/91, p. 43991. 

RTC Minority- and 

Women-Owned Business 

Contracting Program 

The RTC requested comments on 

an interim final rule, issued pursuant 

to a requirement in FIRREA, under 

the agency's program to identify, pro 

mote and certify eligible firms for in 

clusion in its contracting activities. 

The interim final rule is concerned 

only with the outreach portion of the 

RTC's program, that is, to ensure 

maximum participation by minorityand women-owned businesses in the 

competitive process for RTC con 

tracts. It does not address the use of 

bonuses, preferences, or other de 

vices used in evaluating offers to per 

form contracts. In those matters the 

RTC will continue to follow current 

policies and procedures, however, 

comment is being sought on those 

issues. FR, 8/15/91, p. 40484. 

Affordable Housing 

Disposition Program 

The RTC adopted temporary 

amendments to its rule for the AHDP, 

implementing the RTC Funding Act 

of 1991, which, among other things, 1) 

43 
FDIC Banking Review 

expands the RTC affordable housing 

program to include, as eligible resi 

dential properties, single-family prop 

erties held in conservatorship and 2) 

allows the RTC to sell eligible singlefamily properties to qualifying fami 

lies, nonprofit organizations and pub 

lic agencies without regard to 

minimum sales price. 

By this action the RTG can help 

satisfy the demand for affordable 

housing in regional markets where the 

RTC has a large inventory of singlefamily homes. By making houses im 

mediately available through 

marketing events, and selling abso 

lute, with no established reserve 

price, the RTC will avoid further de 

terioration of the existing inventory of 

eligible properties while expanding 

the range of households who can be 

come homeowners through the dispo 

sition of assets of failed S&Ls. 

Important also is the reduced holding 

costs associated with these properties. 

FR, 6/4191, p. 25352. 

Court Bars Suits Against 

Regulators in Management 

ofS&Ls 

The U.S. Supreme Court unani 

mously ruled, in the case of U.S. v. 

Gaubert, that federal regulators cannot 

be sued for damages for losses that the 

regulators are alleged to have caused 

in the management of a savings insti 

tution. 

The Court rejected a finding by a 

federal appeals court in New Orleans 

that a provision of the Federal Tort 

Claims Act that bars liability if the 

government employees are perform 

ing "discretionary" functions does not 

apply to day-to-day management of 

the institution. WSJ, 3/27191,p. A3. 

Operations Update 

There were 166 conservatorships 

under the RTC's management as of 

July 31, 1991, holding $73 billion in 

assets. Cash and securities comprised 

29 percent of the total, performing 1 -4 

family mortgages and other perform 

ing loans 44 percent, delinquent loans 

ten percent, real estate ten percent 

and other assets seven percent. 

Also under the RTC's jurisdiction 

were467 receiverships, resulting from 

the resolution of thrifts since the 

RTC's inception in August 1989, with 

$83 billion in assets (excluding nearly 

$6 billion in cash and liquid assets 

available for payments of expenses 

and dividends to creditors). In the re 

ceiverships, all assets other than cash, 

securities, and performing 1-4 family 

mortgages represented 74 percent of 

the total. Thirty-seven percent of the 

total assets were real estate and delin 

quent loans. 

Sales and principal collections in 

conservatorships and receiverships 

and assets passed to acquirers of re 

solved thrifts since August 1989 to 

taled $179 billion as of July 31, net of 

pucbacks. This total represents 54 

percent of the aggregate assets of the 

633 institutions taken over by the 

RTC at the time they came under its 

control. In asset categories, the RTC 

had disposed of $81 billion in securi 

ties, $70 billion in mortgages, $15 bil 

lion in nonmortgage loans, $6 billion 

in real estate, and $7 billion in other 

assets. RTC Review, RTC, 7/91. 

Operating losses at savings associ 

ations in the RTC conservatorship 

program as of June 30, 1991 rose to 

$728 million in the second quarter, 

from $596 million in operating losses 

by the same institutions in the pre 

ceding quarter. The increase was due 

largely to losses on assets sold in sub 

sidiaries of two large institutions. 

Total losses reported by those institu 

tions in the second quarter amounted 

to $1.6 billion, up by $0.1 billion from 

the first quarter. Over one half of the 

second-quarter loss reflected noncash 

charges to recognize prior losses on 

assets, including net provisions for 

losses on assets, net losses on the sale 

of assets, the write-down of goodwill, 

and other adjustments in asset values. 

PR-402-91, RTC, 9/13/91. 

Federal Reserve Board 

Supervisory Definition of 

Highly-Leveraged 

Transactions 

The FRB, OCC, and the FDIC 

requested public comments on the 

supervisory definition of highly-lev 

eraged transactions (HLTs). Under 

the common definition established in 

1989, a hank or bank holding com 

pany is considered to be involved in 

an HLT when credit is extended to or 

investment is made in a business 

where the financing transaction in 

volves the buyout, acquisition, or re 

capitalization of an existing business 

and oneof certain criteria are met. The 

criteria are: 1) the transaction results 

in a liabilities-to-assets leverage ratio 

higher than 75 percent, or 2) the trans 

action at least doubles the subject 

company's liabilities and results in a 

liabilities-to-assets leverage ratio 

higher than 50 percent, or 3) the trans 

action is designated an HLT by a syn 

dication agent or a federal regulator, 

In their reviews, the three agencies 

will address concerns regarding the 

designation, reporting and delisting of 

HLTs. Also, some borrowers have in 

dicated that the HLT designation is 

viewed as a criticism of credit quality 

by analysts, bankers and investors, 

even though the HLT designation 

does not imply supervisory criticism. 

The FRB began collecting HLT 

data on the Consolidated Financial 

Statements for Bank HoldingCompa

nies in September 1990, and collec 

tion of HLT data began in banks'Call 

Reports in March 1991. Press Release, 

FRB, July 3,1991; FR, 7/10, p. 31464. 

International Banking 

Operations 

The FRB revised its Regulation K 

to permit U.S. banking organizations 

to expand the scope of their interna 

tional activities. The revisions will, in 

part, expand the existing authority to 

engage in underwriting and dealing in 

equity securities outside the U.S.; 

permit Edge corporations to provide 

domestic banking services, including 

44 
Recent Developments 

loans, co foreign persons and govern 

ments; and expand the range of per 

missible activities for U.S. banking 

organizations abroad to include fu 

tures commission merchant activities 

and life insurance underwriting. 

Some of the revisions were effec 

tive immediately, and others were to 

become effective on May 24, 1991. 

Press Re/ease, FRB, 4/19/91; FR, 4/29, p. 19549; 

Af}, 3/28, p. 2. 

Debt and Equity 

Underwriting Approved 

The FRB granted approval for the 

$3.4 billion-asset Dauphin Deposit 

Corporation, Harrisburg, Pennsylva 

nia to underwrite corporate debt and 

equity through the purchase of an in 

vestment firm in Lancaster. The firm 

is a major regional underwriter of mu 

nicipal bonds. 

Thus far only two other domestic 

banking companies, the securities 

units of Bankers Trust New York Cor 

poration, and J.P. Morgan & Co., 

have received such permission. Ana 

lysts believe that the firms most likely 

in the near term to go into these activ 

ities are certain profitable "super

regionals" that have securities 

subsidiaries with limited nonbanking 

powers. Firms of Dauphin's size are 

unlikely entrants because of the ten 

percent limit that the FRB has put on 

the revenues that the securities sub 

sidiary can derive from new under 

writing activities. AB, 718191, p. 2. 

Purchase ofBank ofNew 

England Subsidiaries 

Approved 

The FRB approved the acquisition 

of three failed Bank of New England 

subsidiary banks by Fleet/Norstar Fi 

nancial Group. The three banks had 

$22 billion in assets and $16.8 billion 

in deposits when they were closed. 

Fleet, having been selected by the 

FDIC as the winning bidder for the 

failed banks, as a bank holding com 

pany also required the FRB's ap 

proval for the transaction. 

Though the proposed acquisition 

involved failed banks, the FRB used 

a competitive factors analysis. Bank 

ing markets in Maine, Connecticut, 

and Massachusetts were directly af 

fected, and in five markets issues 

arose over possible anticompetitive 

effects. The U.S. Justice Department 

said the FRB should adopt a different 

method for analyzing the effects of 

acquisitions on relevant banking mar 

kets. The FRB treated savings insti 

tutions as full competitors with 

commercial banks, thus tending to re 

duce the measures of market concen 

tration. Under the Justice Department's 

merger guidelines, a banking market for 

which the Herfindahl-Hirschman 

Index is above 1800 is considered to 

be highly concentrated. The FRB 

said that the lessened competition as 

indicated by the concentration in 

dexes being increased to levels above 

Justice's guidelines is outweighed by 

the substantial public benefits that 

would result. 

In a bank acquisition case earlier 

this year in which the FRB and Justice 

differed on the antitrust aspects, Jus 

tice sued to block the merger. The 

case was settled in March after the 

acquiring bank, First Hawaiian, Inc., 

agreed to several divestitures. BBR, 

7/8/91,p. 37. 

A suit brought by the Department 

of Justice challenging Fleet/Norstar's 

acquisition of a former Bank of New 

England subsidiary (New Maine Na 

tional Bank of Portland) was settled 

when Fleet/Norstar agreed to give up 

branches in three banking markets in 

Maine. Justice said the State of Maine 

agreed to forego a separate antitrust 

suit as a result of the proposed settle 

ment. BBR, 7115, p. 107. 

Court Says Citicorp 

Subsidiary Can Sell 

Insurance 

A U.S. court of appeals (Second 

Circuit of New York) ruled that 

Citicorp can sell and underwrite in 

surance through a subsidiary of its 

Delaware-chartered bank, as permit 

ted under Delaware law. The court 

rejected the FRB's argument that the 

Bank Holding Company Act prohibits 

state-chartered bank subsidiaries 

from engaging in activities, including 

insurance, that are not closely related 

to banking. The court noted that it 

had determined previously that the 

BHC Act does not prohibit a bank 

owned by a holding company from 

selling insurance. 

Banking Commissioner K. H. Ellis 

of Delaware said Citicorp and Chase 

Manhattan are the only two compa 

nies thus far that have applied for and 

received approval to expand their in 

surance activities under the state's 

law. AB, 6/11/91,p. 1, 

Merger Rejected on 

CRA Grounds 

The FRB denied an application by 

the $629 million-asset First Interstate 

BancSystem of Montana, Inc., Bill 

ings, to merge with the $280 million 

Commerce BancShares of Wyoming, 

Inc., Sheridan. The merger would be 

a corporate reorganization of two bank 

holding companies that are under 

common ownership and control. The 

FRB found inadequacies in the CRA 

performance of First Interstate Bank 

of Colstrip, Montana, noting also that 

the bank had received a less than sat 

isfactory CRA rating from its primary 

regulator, the FDIC, in its two most 

recent CRA examinations. There is 

no indication, the FRB said, that the 

reorganization would result in any 

other benefits to the convenience and 

needs of the communities served by 

the companies involved that would 

outweigh the adverse CRA perfor 

mance record of Colstrip. Press Release, 

FRB, 10/7/91. 

Tiered Pricing in CheckCollection Services 

The FRB modified its criteria for 

offering a tiered pricing structure in 

the Federal Reserve's check-collec 

tion service. Among the modifications 

are those to allow tiered pricing in all 

collection zones, and for more than 

two tiers of prices where justifiable 

cost differences exist. The changes 

will enable Federal Reserve Banks to 

set fees that more precisely reflect 

their costs of collecting checks drawn 

45 
FDIC Banking Review 

on paying banks within a given checkcollection zone. These costs are gen 

erally based on the location of, and 

volume of checks presented to, each 

endpoint. Effective: January 1,1992. 

Press Release, FRB, 5/9/91; FR, 5/14, p. 22168. 

Electronic ACH Adopted 

The FRB will require, starting July 

1,1993, all depository institutions that 

originate or receive commercial auto 

mated-clearinghouse transactions 

through the Federal Reserve to do so 

by electronic means. Effective Janu 

ary 1, 1992, ACH paper output fees 

and tape input and output fees will 

be substantially increased. FR, 

6/19/91, p. 28157; ABA Bankers Weekly, 6/18, 

p. 10. 

Study on Mortgage Lending 

An article by FRB staff members 

indicates that significant differences 

exist in loan approval rates among dif 

ferent racial/ethnic groups, with de 

nial of credit more likely for black and 

Hispanic applicants than for white ap 

plicants. 

The report utilized data which 

were recently released by the Federal 

Financial Institutions Examination 

Council (FFIEC) relating to 1990 

mortgage lending activity in metro 

politan areas across the nation. Na 

tionwide aggregates from preliminary 

data, which for the first time contain 

information about the race and na 

tional origin of loan applicants, also 

were announced. 

Federal Reserve Governor John P. 

LaWare, Chairman of the FFIEC, de 

scribed the statistics as "worrisome," 

and said the new data will be used by 

the regulators as an additional tool to 

ensure compliance with community 

reinvestment and fair lending laws. 

The article gives an overview of 

the Home Mortgage Disclosure Act 

(HMDA) reporting system, describes 

analytical studies based on geo 

graphic data available under the old 

system, and discusses some potential 

uses of the new data. It also cautions 

that, given certain limitations of the 

HMDA data, the lending patterns re 

flected by the HMDA statements 

alone cannot establish whether lend 

ers are treating applicants fairly and 

on a nondiscriminatory basis. Fore 

most among the limitations is a lack of 

information in the HMDA data about 

factors important in determining the 

creditworthiness of applicants and the 

adequacy of collateral offered as secu 

rity for their loans. Press Release, FFIEC, 

10/21/91; "Home Mortgage Disclosure Act: Ex 

panded Data on Residential Lending," Federal 

Reserve Bulletin, November 1991, pp. 859-881. 

Office of the Comptroller ofthe 

Currency 

Guidelines for Asset 

Management Services 

The OCC issued guidelines to be 

followed by national banks in manag 

ing assets for other banks, savings as 

sociations, and the RTC or the FDIC. 

The guidelines are concerned with 

procedures for keeping control over 

assets, and identifying risks that are 

involved in asset management. Nu 

merous risks are identified. Among 

the practices for maintaining control 

of assets are board-approved written 

policies and procedures, having docu 

mentation for a sufficient audit, and a 

formal written agreement outlining 

the responsibilities of all parties. 

In managing assets, banks should 

take steps to protect against conflicts 

of interest, such as may arise from 

granting loans on preferential terms to 

facilitate the sale of any managed 

asset, and granting subcontracts to in 

dividuals or entities that have a loan 

that is being managed by the bank. 

BC-254, 6/14/91, OCC; BBR, 7/15, p. 89. 

Civil Money Penalties 

The OCC revised its policy gov 

erning the assessment of civil money 

penalties (CMPs) to provide clear 

guidance to the agency's national 

bank examiners, national banking in 

stitutions, and their institution-affili 

ated parties, and to take into account 

changes in the agency's CMP author 

ity mandated by FIRREA. 

The revised policy provides that 

the OCC may assess CMPs to deter, 

and/or encourage correction of, viola 

tions of law, regulations, orders, con 

ditions imposed in writing and formal 

agreements, reckless or unsafe bank 

ing practices, and breaches of fidu 

ciary duty. The OCC may use its 

CMP authority as deemed appropri 

ate to achieve these objectives. new 

matrix is outlined to be used by exam 

iners for determining the level of fees 

co be imposed for violations. Banking 

Issuance No. 253, OCC, 4/8/91; BBR, 4/22, p. 739. 

Money Penalty for 

Securities Violations 

The OCC imposed a CMP of 

$5,000 against the president of a na 

tional bank in Louisiana for violations 

of rules related to securities offerings. 

Authorized under FIRREA, itwasthe 

agency's first use of the CMP for such 

violations. The violations included a 

public offering in 1989 and 1990 of 

bank stock with an offering circular 

chat the OCC did not clear in advance, 

and offerings of stock in excess of the 

amount authorized. The bank, as di 

rected by the OCC, subsequently re 

scinded the stock offerings and 

returned the funds to investors. 

BBR, 5/20/91, p. 986. 

Enforcement Actions 

The OCC announced on August 

14, 1991, that it would begin issuing 

monthly news releases to disclose en 

forcement actions taken against na 

tional banks and bankers. Information 

on OCC enforcement actions had pre 

viously been available only through 

OCC publications. The 33 enforce 

ment actions disclosed in the initial 

release included six cease-and-desisc 

orders, 16 formal agreements, eight 

CMPs, and three removal actions 

against individuals. New Release, 91-59, 

OCC, 8/14/91. 

Appraisals 

Under proposed changes to the 

OCC's appraisal rule adopted in Au 

gust 1990, regulated institutions 

would not be required to obtain ap 

praisals by certified or licensed ap 

praisers for real-estate-related 

financial transactions having a value, 

46 
Recent Developments 

as defined in the rule, of $100,000 or 

less. The proposed changes also 

would: 1) permit regulated institu 

tions to use appraisals prepared for 

loans insured or guaranteed by an 

agency of the federal government if 

the appraisal conforms to regulations 

or other written requirements of the 

federal insurer or guarantor, and 2) clar 

ify certain definitions. Comments are 

solicited on all aspects of the proposed 

rule. FR, 8128191,p. 42546. 

Community Reinvestment Act 

The OCC amended its CRA regu 

lations to implement provisions of 

FIRREA. The final rule requires na 

tional banks to place their CRA Per 

formance Evaluation in their public 

comment file within 30 business days 

of receipt from the OCC. Among the 

requirements is that national banks 

must make the evaluation available 

for public inspection and provide cop 

ies of the evaluation, upon request, to 

interested parties. 

The three other federal bank and 

thrift regulatory agencies have issued 

a similar rule. FR, 6112191,pp. 26899,2690!, 

26903,26904. 

Lease Financing 

The OCC issued a final rule on 

lease-financing transactions which in 

tegrates the OCC's current Interpre 

tive Ruling, consolidating the 

agency's substantive lease-financing 

regulations, and clarifying the two 

types of lease-financing authority 

available to national banks. These are 

the specific authority contained in the 

Competitive Equality Banking Act, 

and authority in other banking law as 

an activity incidental to banking. FR, 

6/20/9), p. 28314. 

Lending Limits 

The OCC adopted a final rule, ef 

fective August 6, 1991, which in part 

provides that a legally binding written 

loan commitment qualifies as a loan 

and can be funded during its entire 

term, even if a bank's lending limit 

subsequently declines, provided that 

the commitment, when combined 

with a borrower's other outstanding 

loans and unfunded commitments 

qualifying as loans, is within the 

bank's lending limit at the time the 

commitment is made. FR, 8/7/91,p. 37272. 

Securitization of 

Credit-Card Receivables 

The OCC granted approval for 

Household Bank, NA, to establish a 

subsidiary to facilitate the securitiza 

tion by the bank of credit- card receiv 

ables. 

The OCC had not previously ruled 

on whether it is legal for a national 

bank to sell or borrow against creditcard receivables through securitiza 

tion. However, it has approved 

securitization for other types of bank 

loans, including mortgage assets, 

leases, and motor vehicle installment 

sales contracts. BUR, 4/22/91,p. 769. 

Title Insurance Ruling 

Upheld 

The OCC's approval for Chase 

Manhattan Bank, New York, to offer 

title insurance through two subsidiar 

ies was upheld by the U.S. District 

Court for the Southern District of 

New York {American Land Title Associ 

ation v. Clarke). The Court said the 

sale of title insurance is "incidental to 

the express power of a national bank 

to make real estate loans." 

Restrictions placed by the OCC on 

the Chase approval included: 1) the 

borrower would be under no obliga 

tion to use the services of the subsid 

iary, 2) the borrower's choice of title 

insurance would not affect the 

lender's decision on credit, 3) custom 

ers choosing the bank's title insurance 

would not be given preferential treat 

ment, and 4) information would be 

given to customers on the 

subsidiaries' services and the relation 

ship between the bank and subsidiar 

ies. ABA Bankers Weekly, 9/10/91, p. 1. 

Office of Thrift Supervision 

Capital Ratio Requirement 

The OTS proposed, under a re 

quirement of FIRREA, to amend its 

minimum regulatory capital regula 

tions by revising the leverage ratio 

requirement to be no less stringent 

than the leverage ratio adopted by the 

OCC for national banks. The pro 

posed rule would establish a three 

percent leverage ratio (defined as the 

ratio of core capital to adjusted total 

assets) for savings associations in the 

strongest financial and managerial 

condition those with a composite 

rating of 1 under the MACRO rating 

system. All other savings associations 

would be required to maintain lever 

age ratios of at least four percent. Trans

mittal No. 16, 4124191, QTS;FR, 4f22, p. 16283. 

OTS Upheld on Individual 

Minimum Capital 

Requirements 

Individual minimum capital re 

quirements (IMCRs) issued by OTS 

are not subject to court review, the 

U.S. District Court for the District of 

Columbia ruled. Injunctive relief 

sought by Transohio Savings Bank to 

block OTS from issuing the IMCR 

was denied. The Competitive Equal 

ity Banking Act of 1987 gave banking 

regulators the original authority to es 

tablish IMCRs, and this authority was 

reaffirmed by FIRREA. NEWS, OTS, 

8/6/91. 

Inclusion ofInterest-Rate 

Risk into Capital Rule 

Delayed 

The OTS will postpone until late 

1992 the inclusion of an interest-rate 

risk component in its thrift risk-based 

capital rule. The proposal, issued in 

December 1990, would require the 

holding of capital against interest-rate 

exposure equal to 50 percent of the 

estimated decline in the market value 

of an institution's portfolio that would 

result from a 200 basis point swing in 

interest rates either up or down. The 

delay will allow OTS to review sug 

gestions for improving the methodol 

ogy for measuring interest-rate risk, 

and to field test a revised marketvalue model for measuring such risk. 

The three federal bank regulatory 

agencies also are studying ways to in 

corporate interest-rate risk into their 

47 
FD1C Banking Rcvciw 

risk-based capital rules. BBR, 8H9I9I, p. 

294. 

Qualified Thrift Lender Rule 

TbeOTS issued a final rule, effec 

tive July 9, 1991, implementing pro 

visions of FIRREA that require that 

institutions have a minimum of 70 

percent of their portfolio assets in 

housing-related assets to qualify as 

thrifts. Previously the required ratio 

was 60 percent. 

Failure to satisfy the QTL require 

ment means a thrift must either con 

vert to a national bank or be subject to 

penalties: the thrift cannot open any 

new branches, must give up invest 

ment powers that banks do not pres 

ently share, and cannot obtain 

low-cost loans from any Federal 

Home Loan Bank. 

A thrift can lose its QTL status 

when its housing-related invest 

ments, averaged over a two-year pe 

riod, fall below the required 

minimum. The first two-year period 

started July 1,1991, when institutions 

were to begin averaging their qualify 

ing housing investments on a weekly 

basis and reporting the results to OTS 

quarterly. 

thrift can count its investment in 

a subsidiary toward meeting its QTL 

test if 80 percent of the subsidiary's 

revenues are derived from domestic 

residential real estate. NEWS, OTS, 91

176, 718191; FR, 4/26, p. 193 IS; 7/9, p. 31061. 

Review of Officials' 

Appointments 

The OTS issued a proposal im 

plementing Section 914 of FIRREA, 

effective August 9,1989, enabling the 

agency to review the qualifications 

and competence of persons nomi 

nated to serve as directors and senior 

officers of savings associations and 

their holding companies. 

Certain savings associations and 

savings and loan holding companies 

must notify the OTS at least 30 days 

before adding any individual to the 

board of directors or employing any 

individual as a senior executive offi 

cer. An institution is subject to the 

notice requirement if it: 1) has been 

chartered less than two years in the 

case of a savings association, 2) has 

undergone a change in control within 

the preceding two years, or 3) is not in 

compliance with the minimum capital 

requirements applicable to such sav 

ing association or is otherwise in a 

"troubled condition." 

The OTS may disapprove the ad 

dition or employment of such individ 

uals. The OTS must disapprove if it 

finds that the competence, experi 

ence, character, or integrity of an indi 

vidual indicate that the appointment 

would not be in the best interests of 

the depositors of the savings associa 

tion or the public. NEWS, OTS, 8/5/9!;FR, 

8/5, p. 37162. 

Transactions with Affiliates 

and Loan Limits 

The OTS adopted a final rule, 

which was required by FIRREA, that 

limits the amount a thrift can invest in 

affiliates. The rule broadens the cir 

cumstances under which a thrift may 

be required to notify the OTS of 

transactions with affiliates, and in 

creases mandated recordkeeping on 

compliance. 

Loans by a thrift and affiliates to 

the same borrower will be aggregated 

for loans-to-one-borrower purposes, 

and generally are limited to 15 per 

cent of a thrift's capital and surplus. 

FIRREA generally applies to savings 

associations the affiliate-transaction 

limits that are imposed on commercial 

banks. Thus, certain covered transac 

tions are limited to ten percent of a 

thrift's capital and surplus, and the 

overall amount of a thrift's transac 

tions with all affiliates is limited to 20 

percent of its capital and surplus. FR, 

8/25/91, p. 34005; BBR, 7/29, p. 179. 

Accounting Standards 

The OTS proposed a rule, to im 

plement sections of FIRREA, that 

would require all savings associations 

to use accounting standards that are 

prescribed by OTS for purposes of 

determining regulatory compliance 

and reporting. Such standards can be 

no less stringent than the accounting 

standards used by the OCC for na 

tional banks. Transmitta! No. 014, 4/2/91, 

OTS; FR, 3/29, p. 13085. 

Thrifts Permitted to Convert 

to Savings Banks 

The OTS gave approvals for 11 

savings and loan associations to exit its 

jurisdiction in order to convert to 

state-chartered savings banks. The 

S&Ls are in Pennsylvania, Washing 

ton, and Oregon. AB, 5/28/91,p. 2. 

State savings banks, which gener 

ally have broader investment powers 

than S&Ls, are regulated at the fed 

eral level by the FDIC. The FDIC 

has adopted a rule under which a fed 

erally insured S&L that converts to a 

state-chartered bank, either savings or 

commercial, and retains membership 

in SAIF will continue to be subject to 

restrictions on high-risk activities im 

posed on S&Ls by FIRREA. 

Applications Restructuring 

Proposed 

The OTS proposed a comprehen 

sive regulation that would: 1) elimi 

nate or streamline the existing 

application or notice requirement for 

many transactions or activities, 2) es 

tablish "standard" and "expedited" 

application and notice processes that 

would increase the flexibility of sav 

ings associations with satisfactory 

MACRO, CRA, and Compliance rat 

ings to engage in certain new activi 

ties and discourage applications to 

engage in new activities by associa 

tions with lower ratings unless the 

proposed activity would clearly im 

prove their financial or managerial 

condition or CRA or Compliance per 

formance, and 3) replace the applica 

tion requirements on some activities 

with a notice requirement. FR, 8/26191, 

p. 41972. 

Federal Financial Institutions 

Examination Council 

Policy on Securities Activities 

The five member agencies of the 

FFIEC are seeking additional com 

ment on a proposal, issued in January 

1991, on revising the definition of 

48 
Recent Developments 

"high-risk mortgage securities," and 

to specify that such securities are not 

suitable investment portfolio hold 

ings for depository institutions. Highrisk mortgage securities may only be 

acquired to reduce an institution's in 

terest-rate risk and must be reported 

in the trading account at market value 

or as assets held for sale at the lower 

of cost or market value. Other prod 

ucts with risk characteristics similar to 

high-risk mortgage securities may be 

subject to the same supervisory treat 

ment. Disproportionately large hold 

ings of long-term, zero-coupon bonds 

are considered an imprudent invest 

ment practice. (See this Review, 

Spring/Summer, 1991, p. 48). F1L-41

91, 816191, FDIC; FR, 8/2, p. 37095. 

Licensed Appraiser Deadline 

Extended 

The FFIEG extended from July 1 

to December 31, 1991 the effective 

date when federally regulated depos 

itory institutions must use state-certi 

fied or licensed appraisers for 

appraisals in connection with feder 

ally related real-estate transactions 

under Title XI of FIRREA (see this 

Review, Spring/Summer, 1991, p. 49). 

The purpose of the extension, the 

agency said, is to facilitate an orderly, 

nationwide implementation of the re 

quirements. 

In June the FFIEC issued revised 

guidelines for state certification and 

licensing of real-estate appraisers, to 

assist them in establishing effective 

certification and licensing procedures 

for real-estate appraisers involved in 

federally related transactions. Press 

Release, FFIEC, 4/26/91; FR, 5/1, p. 20002; 6/6, 

p. 26088. 

Proposal Withdrawn on 

Return ofLoans with 

Partial Charge-offto 

Accrual Status 

In March 1991 the FFIEC re 

quested comments on a proposal by 

the four federal bank and thrift super 

visory agencies for an accounting 

change, applicable to the institutions 

which they supervise, for returning a 

partially charged off loan that has 

been on nonaccrual status to accrual 

status, without first recovering the 

partial charge-off or becoming fully 

current in accordance with the con 

tractual loan terms. After further conside ration, the agencies are 

withdrawing the proposal. The agen 

cies intend to work with the privatesector rulcmaking bodies to attempt 

to develop a consistent and objective 

accounting treatment with respect to 

the recognition and measurement of 

interest income on nonaccrual loans 

and other loans to borrowers experi 

encing financial difficulties and other 

related issues. FR, 8/5/91,p, 37214. 

Nondiscriminatory 

Treatment ofReal-Estate 

Appraisers 

The FFIEC notified institutions 

that managements should take steps 

to ensure that written policies and 

practices conform with the regulatory 

agencies' non-discrimination regula 

tions which prohibit financial institu 

tions from excluding appraisers from 

consideration solely by virtue of their 

membership, or lack of membership, 

in any particular appraisal organiza 

tion. 

Regulators require financial insti 

tutions to review the qualifications of 

appraisers to ensure that they are 

qualified for the assignment for which 

they are being considered. An 

institution's loan policies must not 

favor appraisers from one or more or 

ganizations or exclude individuals 

based on their lack of such member 

ship. FIL-27-9! (FDIC), 5/24. 

Electronic Submission of 

Bank Reports 

The FFIEC requested public 

comment on a proposed timetable 

under which banks would be required 

to submit their Call Reports electron

ically. In general, banks currently 

have the option of either filing hardcopy (paper) reports or submitting 

their Call Reports electronically. As 

proposed by the FFIEC: 

* Beginning with the March 31, 

1992, Call Reports, banks with 

assets of$100 million or more as 

of June 30, 1991, would be re 

quired to file electronically. 

* Beginning with the March 31, 

1993, Call Reports, banks with 

assets of $50 million or more as 

of June 30, 1991, would be so 

required. 

* Beginning with the March 31, 

1994, Call Reports, all banks 

would be so required. 

The proposed timetable would not 

change the existing deadlines for sub 

mitting Call Reports. F1L-50-91, FDIC, 

10/9; FR, IO/4,p.5O334. 

National Credit Union 

Administration 

NCUSIF Insurance 

Premium 

The NCUA will assess a full pre 

mium of 1/12 of one percent of in 

sured deposits, payable by January 24, 

1992. Insurance premiums have not 

been levied since 1984. In 1985, the 

ratio of the National Credit Union 

Share Insurance Fund (NCUSIF) to 

insured deposits exceeded 1.30 per 

cent, and pursuant to the Federal 

Credit Union Act, a dividend of five 

percent of insured deposits was paid 

to credit unions to reduce the ratio to 

1.30 percent. 

Insurance losses to the NCUSIF 

will be $160-170 million in the fiscal 

year ending September 30, 1991, of 

which $120 million represents re 

serves charged to cover potential 

losses of three major problem credit 

unions in Massachusetts. NCUSIF 

insurance losses per$l,000 of insured 

deposits increased to approximately 

$.84 in FY 1991, from a five-year av 

erage loss of $.54. 

Income to the NCUSIF from the 

premium will be increased by $41 mil 

lion that would be recognized in FY 

1991, and $123 million in FY 1992, for 

a total of $164 million, plus a pro 

jected $12 million in annual invest 

ment income. The NCUSIF, 

estimated with the premium to be 

49 
FDIC Banking Review 

about $444 million at September 30, 

1991, amounted to 1.23 percent of in 

sured deposits, and is expected to rise 

to 1.26 percent on September 30, 

1992. Without any premium, the 

NCUSIF's gross revenue would con 

tinue to depend entirely upon its in 

come from investments. The 

NCUSIF would have showed a net 

loss for FY 1991 of $36 million, and a 

gain of only $2 million would occur in 

1992. The equity ratio would have 

been 1.20 percent on September 30, 

1991, and would fall to 1.18 percent on 

the same date in 1992. Board Action Mem 

orandum, NCUA, 8/23191. 

Real-Estate Lending 

Guidelines 

The NCUA issued guidelines to 

federally insured credit unions to clar 

ify areas of risk and concern in resi 

dential real-estate lending. The 

agency expects to propose regulatory 

provisions in this area within the near 

future. 

The NCUA emphasized that 

credit unions that grant residential 

real-estate loans should have a written 

lending policy, which should be re 

viewed at least annually, and should 

include at a minimum certain infor 

mation which is itemized in the 

guidelines. Also addressed are sec 

ondary market activities, asset/liability 

management, fixed- and adjustablerate loans, staffing, construction loans, 

and compliance with consumer pro 

tection laws. 

Real-estate-secured loans at feder

ally insured credit unions have in 

creased over 137 percent in the last 

five years. Although growth during 

1990 slowed to a nine-percent rate by 

year-end, over 34 percent of all loans 

outstanding at federally insured credit 

unions were secured by residential 

real estate. Letter No. 124, NCUA, June 1991. 

Business Loan Rules Adopted 

The NCUA amended, effective 

January 1, 1992, its rules on member 

business loans that were initially 

adopted in 1987. The existing rule 

and increased examination and super 

vision efforts have not been sufficient 

to stem losses, and changes in the rule 

are necessary to limit certain high-risk 

activities. The changes will require 

greater diversification, revised collat 

eral requirements and overall limits 

on certain types of lending. In addi 

tion, the NCUA's ability to identify 

and monitor business lending activity 

will be improved. 

Among the revisions are: 1) a limit 

on loans-to-one-borrower of 15 per 

cent of reserves, less the allowance for 

loan losses, or $75,000, whichever is 

higher; 2) a requirement for quarterly 

monitoring reports by credit unions 

with aggregate business loans greater 

than 100 percent of reserves, and in 

formation on loans delinquent 30 days 

or more; and 3) a requirement that 

business loans be made for periods 

consistent with their purpose, secu 

rity and creditworthiness. Maturity is 

limited to 12 years for federal credit 

unions. FR, 9125191, p. 48421; ABA Bankers 

Weekly, 10/1, p. 4. 

Loan Purchases Requiring 

NCUA Approval 

A final rule will require any 

NCUSIF-insured credit union to ob 

tain approval from the NCUA Board 

before either purchasing or acquiring 

certain loans or assuming or receiving 

an assignment of certain deposits, 

shares or liabilities of any credit union 

not insured by the NCUSIF, of any 

other financial-type institution, or of 

any successor in interest to either such 

institution. Certain credits notsubject 

to the approval process are specified. 

Effective: August 28, 1991. FR, 7129191, 

p. 35808. 

Accounting Rule Changes 

Real Estate: An issuance in June 

reaffirms that generally federal credit 

unions are not permitted to hold 

"other real estate owned" (OREO) for 

the production of income. OREO is 

presumed, therefore, to be held for 

sale. Revising its policy, the agency 

states that at foreclosure, OREO 

should be carried at the lower of cost 

or fair value. After foreclosure, the 

carrying amount of OREO held for 

sale should not exceed its fair value 

reduced by the estimated cost to sell 

the asset. "Cost" and "fair value" are 

defined in the NCUA's statement. 

Accounting Bulletin No. 91-2, NCUA, 6191. 

Income Accrued on Delinquent Loans: 

Federal credit unions are instructed 

that, effective immediately, interest 

should not be accrued on loans three 

months or more delinquent. Pre 

viously, the interest accrual period for 

delinquent loans was six months. An 

unchanged policy is that accruals of 

interest on loans should be reversed 

when the loan is determined to be a 

loss or when it becomes 12 months 

delinquent, whichever occurs first. 

Accounting Bulletin No. 91-!, NCUA, 6/91. 

State Legislation and 

Regulation 

Interstate Banking 

New Jersey: The Department of 

Banking will allow, effective im 

mediately, participating members of 

the MAC teller machine network in 

New Jersey to accept and transmit 

ATM deposits from cardholders 

whose accounts are held in Pennsyl 

vania and Delaware financial institu 

tions. Under a reciprocal arrangement, 

New Jersey MAC cardholders can do 

these transactions through participating 

MAC machines in Delaware and Penn 

sylvania. MAC cardholders in Delaware 

and Pennsylvania already have been 

able to carry out these ATM transac 

tions in each other's state. 

MAC has over 950 member finan 

cial institutions in Delaware, Florida, 

Maryland, New Hampshire, New Jer 

sey, New York, Pennsylvania, and 

West Virginia. AB, 7112191,p. 3. 

North Dakota: The Banking Board 

approved South Dakota and Minne 

sota as having interstate banking laws 

similar to the state's law. North 

Dakota's law, which permits nation 

wide, interstate banking on a recipro 

cal basis, became effective on July 1, 

1991. South Dakota has previously 

ruled that North Dakota has an inter 

state law similar to its own law. North 

western Financial Review, 6/8/91, p. 26. 

50 
Recent Developments 

Rhode Island: The state and other 

regulators granted approvals that have 

enabled Shawmut National Corpora 

tion to create an interstate bank, by 

converting its Rhode Island bank sub 

sidiary into branches of Connecticut 

National Bank. 

Only five states — Connecticut, 

Rhode Island, Delaware, Utah and 

Wyoming — permit out-of-state 

acquirers to operate the banks they 

acquire in the state as branches. 

The Bush Administration has pro 

posed, as part of its package of bank 

ing reforms, to permit national banks 

to branch into any state in which the 

bank's holding company could ac 

quire a bank. After three years, this 

geographic limitation on interstate 

branching would cease to exist. AB, 

4116191, p. 2; Modernizing the Financial System, 

U.S. Department of the Tr-easwy, February 1991, 

pp. 51-52. 

Intrastate Banking 

Colorado: Under a bill passed by 

the legislature, any Colorado bank or 

thrift would be permitted to acquire 

another financial institution and con 

vert it to a branch. Beginning July 1, 

1993, each Colorado bank or thrift 

could establish one new branch. Un 

limited statewide de novo branching 

would be allowed effective January 1, 

1997. 

Sixty percent of a banking 

company's subsidiary banks could be 

converted to branches during the pe 

riod from August 1, 1991 to July 1, 

1992, and from then until July 1993 

another 20 percent could be con 

verted, and finally, after June 30,1993 

all of a company's banks could be con 

verted. AB, 5110191,p. 2. 

State's Thrift and Loans Are 

Federally Insured 

California; AW of the 49 Californiachartered thrift and loan institutions 

are now federally insured, a state offi 

cial said. 

The state legislature had set a July 

1, 1990 deadline for the thrift and 

loans to obtain federal insurance. The 

state's action followed the insolvency 

in 1984 of Western Community 

MoneyCenter, an industrial loan 

company, whose obligations ex 

ceeded the capacity of the private in 

surer, Thrift Guaranty Corporation, to 

cover its debts and provide insurance 

for other thrift and loans covered at 

that time. BBR, 4115191,p. 698. 

Access to Thrifts' Records 

Expanded 

California: A new law permits 

stockholders and members, individu 

ally or as a group, that hold one per 

cent or more of the voting shares of a 

savings and loan association, or voting 

shares worth $100,000 or more, and 

have held the shares for at least six 

months, to make extracts from the 

registrar, books or minutes for pur 

poses "reasonablyrelated" totheirin

terests. The rights of inspection and 

extraction are extended to an 

association's subsidiaries. Certain 

confidential information is specific 

ally excluded. BBR, f0/7/91, p. 568. 

Bank Assistance Plan 

Connecticut: The legislature passed 

a bill that would establish the Con 

necticut Bank Funding Corporation, 

to buy stock in troubled state-char 

tered banks to prevent their failure. A 

recapitalization could require bank 

management to be removed and 

shareholders to lose most of their in 

vestment. The new corporation could 

also arrange for mergers of institu 

tions. 

The bill provides that up to $10 

million in state funds could be in 

vested in CBFC,and additional funds 

would be drawn from outside invest 

ors. Chairman L. William Seidman 

said that FDIC officials are discussing 

with state authorities the question of 

FDIC participation in the program. 

AB, 6/7/91, p. 1. 

New Reporting Rules on 

Insider Loans 

Connecticut: Beginning with sec 

ond-quarter reports to regulators, 

state-chartered banks must provide 

quarterly the amount of loans to their 

directors and senior officers. More de 

tailed information is required if the 

total amount of insider loans exceeds 

25 percent of the bank's capital, or if 

loans to a single official represent 

more than ten percentof capital. Also, 

a requirement for more information is 

triggered if insider loans are provided 

on terms unavailable to other borrow 

ers or if collection of the loans is un 

likely. AB, 4/23/91, p. 7. 

Environmental Liability Is 

Restrictedfor Lenders 

Illinois: The Governor signed leg 

islation exempting financial institu 

tions from liability for hazardous 

waste cleanup on property they ac 

quire by foreclosure or other means of 

credit extension. The institutions are 

liable for the costs of cleanup only if 

they exercise "continual or recurrent 

managerial control that caused the re 

lease" of the hazardous materials. BBR, 

9/30/91, p. 517. 

Missouri: Under a new law, effec 

tive August 28, lenders are absolved 

from cleanup costs or any third-party 

liability when a property is contami 

nated before the lender takes it under 

direct control in a foreclosure or re 

ceipt of an assignment on a debt. The 

lender in control of the property con 

tinues to have immunity, even if the 

contamination remains, providing the 

lender does not "knowingly or reck 

lessly" cause, or allow others to cause, 

additional pollution. Among other re 

quirements, the lender must make 

"reasonable efforts" to re-sell the 

property. BBR, 9/9/91,p. 364. 

Enforcement Authority 

Iowa:The legislature passed a bill 

giving the Superintendent of Banking 

additional authority, similar to en 

forcement powers granted to federal 

regulators in FIRREA, to remove an 

officer or d irector from a state bank, or 

to require a person affiliated with a 

state bank to stop participating in the 

affairs of the bank, if the person has 

violated a law or regulation. Northwestern 

Financial Review, 6/8191, p. 34. 

5] 
FDJC Banking Review 

Limits on Liability of 

Attorneys, Accountants 

Louisiana; A new law limits the lia 

bility of attorneys, accountants, and 

their firms, who represent federally 

insured financial institutions. The re 

sponsibility of Louisiana-licensed at 

torneys is limited to that provided 

under Louisiana's Rules of Profes 

sional Conduct, and the duty of certi 

fied public accountants is established 

by GAAP and generally accepted au 

diting standards. The liability of those 

professions is limited to the tradi 

tional limits of legal or accounting 

malpractice, "judged under accepted 

standards within the locality where 

such attorney or certified public ac 

countant practices." Attorneys or ac 

countants serving as directors or 

officers of insured institutions must 

adhere to the same fiduciary stan 

dards as other officers and directors. 

BBR, 7/29/91,p. 172. 

Banks Can Sell Insurance 

Under SBLI Laws 

Massachusetts: New legislation per 

mits commercial banks to sell life in 

surance under the state's 

long-standing savings bank life insur 

ance laws. Previously under these 

laws the power to sell life insurance 

was granted only to savings banks in 

the State. ABA Bankers Weekly, 1/29/91,p. 6. 

Low-Cost Checking 

New Jersey: The Banking Depart 

ment is seeking comments for a lowcost checking account, as required 

under state legislation signed in July. 

The Banking Department must es 

tablish by its regulations certain spe 

cific account features, among which 

are the initial amount required to 

open the deposit account, the maxi 

mum allowable minimum balance 

that may be required to maintain the 

account, and the maximum monthly 

fee for maintaining the account. The 

requirements arc likely to be stated in 

terms of a range of options rather than 

specific numbers. Also, an institution 

may seek on an individual case basis 

the approval of a consumer account 

that does not conform to regulations. 

BBR, 8/5191,p. 225. 

FDIC Liability Limited in 

Open-Bank Assistance 

New Hampshire; The Governor is 

expected to sign a bill that would aid 

the FDIC in open-bank assistance 

cases in respect to contingent liability. 

The measure would extend to these 

cases the protections to the FDIC 

under a decision of the U.S. Supreme 

Court in the case of D'Oench, Duhme & 

Co. v. FDIC, 1942. The Court ruled 

that the FDIC or the purchasers of 

failed institutions cannot be sued on 

the basis of agreements, such as bor 

rowers' transactions, and executive 

compensation plans, that do not ap 

pear on the records of the failed insti 

tution. BBR, 6/3191, p. 1047. 

Lender Recovery Limited on 

Foreclosed Property 

Texas: new law permits borrowers 

having real estate foreclosed to ask a 

court to determine the "fair market 

value" of the property on the date of 

the foreclosure sale. If that value is 

found to exceed the foreclosure sale 

price the borrower is entitled to a 

credit for the difference, to be applied 

to the amount owed. Factors that may 

be used to determine "fair market 

value" are specified. 

The law reduces to two years, from 

four years previously, the period dur 

ing which a lender may sue for recov 

ery of a deficiency between an unpaid 

indebtedness and the foreclosure sale 

price of the real property securing the 

loan. 

The new law applies to foreclosure 

sales transacted on or after April 2, 

1991. BBR, 4/8191, p. 648. 

Bank and Thrift Performance 

Banks' Earnings Decline 

Insured commercial banks in the 

U.S. earned $4.6 billion in the second 

quarter of 1991, a decline of 7.8 per 

cent from the first quarter, and 12 

percent from the second quarter a 

year ago. Higher loan-loss provision 

ing was the primary reason for the 

decline in bank profits. Loan-loss re 

serves expensed in the second quarter 

were 15.5 percent higher than in the 

first quatter, and 26.2 percent above 

the second quarter of last year. The 

largest increases in loss provisions oc 

curred at banks in the West and 

Northeast Regions. Banks in these 

areas also experienced the largest de 

clines in net income. 

For the first six months of 1991, 

insured commercial banks' net in 

come totaled $10.3 billion, down by 

$1.2 billion, or 10.4 percent, from the 

first half of 1990. Net interest income 

was $3 billion higher than in 1990. 

while loan-loss reserves provisioned 

were $3.1 billion higher, and net noninterest expenses were $1.7 billion 

higher. The FDIC Quarterly Banking Profile, 

Second Quarter, 1991, 

Bank Failures and 

"Problem" Banks in 1991 

In the firstsix months of 1991 there 

were 57 commercial bank failures, 

well below the 99 for the same period 

a year ago. However, the average size 

of banks failing in 1991 $475 mil 

lion was more than seven times the 

average size of those failing in the first 

half of 1990. The number of "prob 

lem" commercial banks continues to 

fall, to 975 at midyear. While this is 

[he lowest number since 1985, the 

aggregate assets of banks on the 

"Problem List" have increased above 

previous quarterly levels. 

Aside from the failing banks, there 

were 190 unassisted mergers in the 

first half of 1991, compared to 199 in 

the first six months of 1990. Sixty-one 

commercial banks were established in 

the first six months of 1991, the lowest 

annual rate since 1965 when 115 char 

ters were issued. On June 30, 1991 

there were 12,150 insured commercial 

banks in operation in the U.S., a de 

cline of 190 in the first six months of 

the year, and 2,050 fewer than at yearend 1986. The FDIC Quarterly Banking Profile, 

Second Quarter, 1991. 

52 
Recent Developments 

Private-Sector Thrifts 

Continue Profitable 

For the first time since 1986 the 

private-sector thrifts have reported 

positive earnings in two consecutive 

quarters. Their net income of $386.8 

million in the second quarter of 1991, 

although down from $610.1 million in 

the first quarter of this year, contrasts 

with a $302.1 loss in the second quar 

ter of 1990. 

Eighty-five percent (1,875 thrifts) 

continue to be profitable. These insti 

tutions had after-tax income of $1.4 

billion in the second quarter, which 

was partially offset by losses of $1.0 

billion incurred by the 15 percent 

(343) that were not profitable. Virtu 

ally all of these losses were caused by 

substantial increases in loan-loss re 

serves at certain institutions. 

Discussing the industry's profit 

ability, OTS Director T. Timothy 

Ryan cited the government's substan 

tial success in its program to close 

failing and insolvent thrifts, and the 

fact that the thrifts' cost of funds (in 

terest on deposits and borrowings) has 

declined faster than the interest they 

earn on their loan portfolios. 

As of June 30, 1991 there were 

2,216 thrifts in the private sector, 

down by 67 in the quarter. Forty-five 

institutions were transferred to the 

RTG during the second quarter. 

Twenty-four institutions were in 

volved in unassisted mergers or con 

versions to another type of institution. 

NEWS, OTS, 9/5/91. 

Large Increase Last Year in 

Banks' Foreclosed Property 

Holdings 

Foreclosed real estate held by 

commercial banks rose 55 percent last 

year, up from a 22-percent increase in 

1989, according to an American Banker 

report. At the year-end, banks1 noncurrent real-estate loans were 27.5 

percent of their equity capital, com 

pared to 14.4 percent a year earlier. 

Lending by banks on real estate 

continued to grow in 1990, as their 

total real-estate loans increased by 8.8 

percent, the report said. However, 

loan growth was down from 12.8 per

centin 1989,and from 14.6 average for 

the five years ending in 1989. The 

growth of banks' commercial real-es 

tate lending last year declined by a 

larger amount, to 3.7 percent from 

10.6 percent in 1989. Their lending 

for construction and land develop 

ment, which is generally their riskiest 

type of real-estate lending, actually 

fell in total dollar amount in 1990. 

While their total loans secured by 

commercial properties (defined as 

nonfarm nonresidential properties) 

rose by 10.4 percent, this was 3.5 per 

centage points below the rate of 

growth in 1989. AB, 5/14/91, p. I. 

Banks' and Thrifts* CRA 

Performance Rated 

Of nearly 3,200 bank GRA exami 

nations conducted since July 1, 1990 

by federal regulators, 9.8 percent of 

the institutions were found needing 

improvement. In about 500 thrift ex 

aminations by OTS, the percentage 

was 16.8 percent. Less than one per 

cent of banks, and nearly three per 

cent of thrifts, were found to be in 

substantial noncompliance. BBR, 

7122/91, p. 137. 

Credit-Card Loan Growth 

Slowed in 1990 

Bank credit-card loan growth 

slowed to 2.8 percent in 1990 from 

13.7 percent in 1989, at the 100 largest 

banks in this category of lending, ac 

cording to the annual American Banker 

survey. The slower growth in card 

loan outstandings is attributed partly 

to the effects of the recession, and to 

some extent to the greater securitiza

tion of loans at some banks. While 

credit-card loans grew by less than 

three percent, home-equity loans 

were up by 21 percent at the top-bank 

group in 1990. 

A decline in credit-card usage is 

evidenced by the amount that the av 

erage cardholder is charging, falling 

from $2,256 in 1990 to $2,110 cur 

rently. study of 30 banks found that 

they lost five percent of their active 

accounts during the first six months of 

1991. At the same time, average re 

volving account balances have risen 

from $1,489 in 1990 to $1,626 cur 

rently. These developments are seen 

by some analysts as suggesting that a 

movement to better card loan quality 

may be occurring. 

Net income from card operations at 

the top banks in the ABA survey ag 

gregated $9.2 billion in 1990, down 

two percent from 1989. The decline 

reflects the lower volume, as well as 

increases in charge-offs co 3.4 percent 

of card loans at year-end from 2.9 per 

cent the year before. Credit-card 

lenders are benefitting, however, in 

making healthy loans from a favorable 

interest-rate spread. The industry is 

undertaking at this time some actions 

that appear encouraging to expand 

credit-card activity, such as promoting 

usage in supermarkets. 

The credit-card leader among 

banking organizations is still Citicorp, 

with $19.5 billion in outstandings, in 

cluding all of its subsidiaries. This 

total was off by $3 billion, or 14 per 

cent, from 1989. Among individual 

banks, Chase Manhattan Bank (USA) 

of Delaware, with $10.4 billion, took 

over the top spot. AB, 9/10/91, p. l. 

Agricultural Banks Continue 

Improved Performance 

Farm banks reported improved 

profitability in 1990, as in each of the 

three preceding years, according co an 

American Bankers Association report. 

The banks' return on assets in 1990 of 

0.99 percent was far above the 0.4 

percent recorded at the bottom of the 

agricultural recession in 1986. 

For farm.banks in the U.S., capital 

rose to over nine percent of assets in 

1990, from 8.72 percent in 1986. Asset 

quality has improved, as evidenced by 

declines in nonperforming assets. 

The banks' loan-to-deposit ratios fell 

by one percentage point in 1990 to 

53.7 percent. 

Total farm debt, excluding opera 

tor households, estimated to be $134 

billion in 1990, was 31 percent less 

53 
FDIC Banking Review 

than the peak level in 1983 and 1.3 

percent below 1989. 

Agricultural banks, numbering 

4,156 in 1990, are defined in the re 

port as having agricultural loans of 

more than 16 percent of total loans, 

and total assets less than $500 million. 

ABA Bankers Weekly, 8/6191, p. 6. 

Large-Bank Mergers Planned 

BankAmerica Corporation, San 

Francisco, and Security Pacific Cor 

poration, Los Angeles, agreed to 

merge. The combined company 

would have $194 billion in assets, sec 

ond in size in the nation to the $217

billion Citicorp. The banking 

company would rank first by deposits 

in Washington, Arizona, and Nevada, 

second in New Mexico, and in the top 

five in Oregon, Alaska, and Idaho. AB, 

8113191, p. 1. 

Chemical Banking Corporation 

and Manufacturers Hanover Corpora 

tion, New York, will merge, creating a 

$135 billion-asset banking company. 

Following the BofA Security Pacific 

merger, Chemical Banking Corp. 

would be the third-largest banking 

company in the U.S., with 660 

branches in New York, New Jersey, 

and Texas, of which 70 are expected 

to be closed. AB, 7116191,p. 1. 

NCNB Corporation, Charlotte, 

N.C., concluded an agreement with 

C&S/Sovran Corporation, At 

lanta/Norfolk, to merge. The result 

ing $118 billion-asset institution, to 

be named NationsBank, would be the 

fourth-largest bank holding company 

in the U.S. The firm will have 1,900 

full-service banking offices in nine 

states and the District of Columbia. 

AB, 7123191, p. 1. 

Commercial Banks Joining 

FHLB System 

About 265 commercial banks have 

joined the Federal Home Loan Bank 

System since 1989. The banks1 bor 

rowings from the FHL Banks have 

totaled over $1 billion. The majority 

of these new members were commu 

nity banks with less than $100 million 

in assets; however, several $1 billionplus banks also have joined the Sys 

tem. Prior to enactment of FIRREA 

only savings institutions were allowed 

to join the FHLB System. Since the 

enactment of FIRREA, membership 

in the $165 billion-asset FHLB Sys 

tem has fallen from 3,300 institutions 

to 2,900 due to the loss of savings 

institutions. 

Advantages to commercial banks 

of membership in the System include 

having a dependable, alternate source 

of liquidity. Commercial banks join 

ing the System are required to pur 

chase FHLB stock equal to one 

percent of their residential mortgage 

assets, or three-tenths of one percent 

of total assets, whichever is greater, 

and must purchase additional stock 

whenever they borrow from a FHL 

Bank. Banks receive dividends on 

their FHLB stock. Under FIRREA, 

FHL Banks' advances to nonmem

bers were eliminated. Among 

FIRREA's requirements for banks 

joining the System is that they must 

have at least ten percent of assets in 

residential mortgage loans. ABA Bankers 

Weekly, 7/30/91, p. 4. 

Recent Articles and Studies 

Banking System Reform: 

Core Banks 

In these proposals for banking re 

form, Lowell L. Bryan envisions the 

creation of a banking system "without 

artificial boundaries, without wasteful 

duplication of effort, and with only as 

much regulation as is needed to create 

an orderly financial system." 

Banks would have to separate their 

"core banking" activities from their 

other businesses. The non-core activ 

ities would be conducted in other, 

separately funded subsidiaries which 

could include investment companies, 

securities companies, and finance 

companies, in respect to which the 

Securities and Exchange Commission 

would be the regulator. 

Deposits would be federally in 

sured only in the core banks. These 

banks would finance home mort 

gages, market credit cards, lend to 

small businesses to finance accounts 

receivable, and provide other such 

traditional banking services. The core 

banks would be protected by addi 

tional restrictions, including 1) peg 

ging the deposit interest rates they 

could pay to the floating rates on com 

parable Treasury securities; 2) further 

restricting loan size, using a sliding 

scale with a lower percentage-of-cap

ital limit applicable to the larger 

banks; and 3) imposing more restric 

tions on banks' real-estate lending, for 

example, regulators could require that 

developers provide 30 percent of eq 

uity in a project, and for construction 

loans that the building be 90 percent 

preleased. 

Under the proposal, the core bank 

ing industry would become much 

smaller than the existing industry, 

and there would be an extensive re 

structuring across the nation into 

fewer banking institutions. The re 

turn on the deposits that remain in the 

industry would be improved. In part 

this would result from the elimination 

of the overbidding for deposits by 

weak competitors. Core banks could 

operate with much less equity capital 

than is presently needed, and the cost 

of equity would be less, because 

banks' earnings would be less volatile 

and of higher quality than those of the 

"bundled" commercial banks. 

An opponent of the core bank ap 

proach (Thomas L. Ashley, American 

Banker, 6/27/91) believes that the rate 

cap, even with the flexibility pro 

vided, would at times cause serious 

loss of deposits through disintermedi

ation. He states that the control 

scheme would be vastly complicated, 

and in fact unworkable, in states that 

have high income tax rates and where 

the rates paid on deposits must reflect 

that factor. 

There is no evidence, Ashley says, 

that the existing legal lending limit is 

a cause of problems for the BIF. A 

lower limit could impair the ability of 

midsize banks to fully meet the bor 

rowing needs of companies of even 

moderate size, thereby forcing some 

54 
Recent Developments 

lending into the larger institutions. At 

the same time, the lower limit will not 

prevent institutions' overlending to 

certain areas of the economy, as hap 

pened in the 1980s. 

Under the proposal the banking 

system could experience a shrinkage 

of as much as $1.5 trillion, or one third 

of all bank and thrift assets. Ashley 

sees a resulting credit crunch in 

which, as capital and assets massively 

shift from banks to nonbank institu 

tions, many borrowers would pay 

more for loans and others would lose 

all access to reasonably priced credit. 

Finally, the core banking approach 

would be against international trends 

where other countries are consolidat 

ing and integrating their financial sys 

tems. Harvard Business Review, May/June, 

1991, pp. 73-86. 

Interstate Branch Banking 

The writer, David L. Mengle, at 

tempts to show that interstate branch 

ing is a logical step in the evolution of 

the structure of U.S. banking. From 

the standpoint of banking efficiency, 

interstate branching would offer sig 

nificant advantages compared to in 

terstate holding companies and 

subsidiary banks. Under the present 

system, each subsidiary must have a 

separate board of directors, must sub 

mit separate regulatory reports and 

undergo separate examinations, must 

maintain its own support and control 

functions for such things as personnel 

and budget, and its own computer 

systems for certain activities. Also, in 

payments-processing a branching 

structure increases the number of 

"on-us" checks presented that can be 

cleared internally. 

Disadvantages of converting to a 

branching system may include the 

loss of the name of the established 

bank, and loss of its board of directors, 

which typically is a valuable source of 

loan referrals. The headquarters man 

agement may lack experience in man 

aging an extensive branch network, 

and in this case a decentralized man 

agement structure may be preferable. 

In addition, for banks of a certain size, 

because of the tiered structure of re 

serves required by the Federal Re 

serve, the costs of maintaining 

reserves are lower for the holding 

company structure. 

The lower costs comparatively, 

Mengle says, of establishing branches 

would lead to increased banking com 

petition, and resulting benefits to the 

consumer. There would be consumer 

benefits also from access across state 

lines to the full services of a bank. 

The effectof interstate branchingon 

small banks would largely depend on 

the laws of the various states. In states 

with liberal branching laws, there might 

be little effect on the number of small 

banks. In the Fifth Federal Reserve 

District, for example, where all states 

allow statewide branching, the fact that 

there are substantial numbers of small 

banks (under $500 million in assets) 

suggests that the great majority of small 

banks would remain in operation even 

if interstate branching were permitted. 

Within states with liberal branch 

ing laws, a trend of converting subsid 

iaries into branches is occurring. 

While this reflects in some degree the 

benefits of decentralization, the expe 

rience has varied widely among insti 

tutions. 

One way an interstate branching 

system could develop would be to 

allow national banks (as the Adminis 

tration has proposed) to branch inter 

state where interstate holding 

company bank acquisitions are per 

mitted. This approach would put 

state-chartered banks at a competi 

tive disadvantage if they were not 

granted a similar power. An alterna 

tive that preserves the authority of the 

states would be interstate branching 

with host-state regulation. An exam 

ple is the agreement by Utah to allow 

a state-chartered bank in Arizona to 

maintain a Utah office as a branch. 

(The Arizona bank had previously 

been a thrift, which was taken over by 

the RTC and then purchased by 

BankAmerica Corporation) Under 

host-state regulation, however, where 

states retain the ability to block the 

process there is doubt as to how much 

interstate branching would actually 

occur. Economic Review, Federal Reserve Bank 

ofRichmond, NovetnberjDecember 1990, pp. 3-17. 

Banking Market Structure 

Effects on Commercial 

Lending 

This paper, by Timothy H. 

Hannan, of the Federal Reserve 

Board staff, seeks to test two bases 

underlying current antitrust analysis 

in banking. One is that some bank 

product markets are local in nature. 

The other, frequently referred to as 

the structure-performance hypothe 

sis, is that firms operating in more 

concentrated markets are more likely 

to engage in some form of noncom

petitive behavior. These accepted 

beliefs have resulted in an antitrust 

policy that seeks to deter undue con 

centration as it applies to local bank 

ing markets. The validity of these 

tenets of bank antitrust analysis is 

tested in this study as they apply to 

commercial lending. 

Using data from the Federal 

Reserve's Survey of the Terms of 

Bank Lending to Business, cross sec 

tions representing the interest-rate 

peak of 1984, the stable interest-rate 

period of late 1985, and the interestrate trough of 1986 are examined. Sig 

nificant local-market effects are 

found for all three cross sections, 

while strong support for the domi 

nance of the structure-performance 

hypothesis in explaining the relation 

ship between commercial loan rates 

and market concentration is found for 

two of the three cross sections. 

The study concludes that the re 

sults are consistent with the existence 

of local bankingmarkets and the dom 

inance of competitive differences as 

an explanation for observed differ 

ences in loan rates. Journal of Banking and 

Finance, February 1991, pp. 133-49. 

Banking Consolidation Trend 

Is Viewed Negatively 

The authors, J. H. Boyd and S. L. 

Graham, of the Federal Reserve Bank 

of Minneapolis, observe that the 

55 
FDIC Banking Review 

banking industry in the U.S. has been 

rapidly consolidating in recent years, 

moving to fewer and larger averagesize banks. Since the post-Depression 

high of about 14,500 banks in 1984, 

the number of insured commercial 

banks dropped to 12,300 in 1990. This 

decrease reflects primarily the absorp 

tions of troubled and healthy banks 

into branches of other banks. The de 

crease has connnued even though the 

rate of formation of new banks in the 

past five years has been only slightly 

slower than in the first half of the 

1980s, and faster than in the 1960s or 

1970s. More important is the decline 

in the number of banking organiza 

tions by 24 percent between 1976 

and 1990 reflecting the acquisition 

and conversion of independent banks 

into bank holding company subsidiar 

ies. From 1977 to 1990 the domestic 

market share of the 100 largest U.S. 

banking organizations increased form 

50 percent to 65 percent. Most of 

these gains occurred at banks ranked 

11th or lower. 

Economies of scale, the authors 

state, do not continue beyond banks 

of a "modest" size, and in fact there is 

some evidence that very large bank 

ing firms are less profitable than mid 

dle-size ones. The explanation of the 

consolidation movement is thus not 

found primarily in market forces, but 

in various public policies. One of 

these policies is "too-big-to-fail," 

which the writers say gives a subsidy 

and an incentive for large banks to 

grow larger, though they provide no 

empirical evidence from the consoli 

dation record to support this view. An 

other regulatory policy encouraging 

larger bank size is the (unintentional) 

regulatory protection that bank man 

agers often enjoy from hostile take 

overs. At the same time, bank 

managers appear to have an incentive 

for consolidation from the fact that 

while the compensation that the top 

managers receive is not significantly 

related to either profitability or asset 

growth, it is positively and signifi 

cantly related to asset size. A final 

government policy is the "liberalized 

attitude" of the U.S. Department of 

Justice and the regulatory agencies 

toward mergers within the same mar 

ket. This policy is reflected, for exam 

ple, in a rise in the 3-bank 

concentration ratio in U.S. urban mar 

kets since 1982. The writers cite evi 

dence from other studies suggesting 

that a relationship exists between 

market structure and pricing — 

higher loan rates and lower deposit 

rates are seen in more concentrated 

markets. Quarterly Review, Federal Reserve 

Bank ofMinneapolis, Spring 199!, pp. 1-14. 

Credit Union System Reforms 

This study by the GAO, which was 

required by FIRREA, discusses the 

financial condition of credit unions 

and their NCUSIF, regulation and su 

pervision of credit unions, the struc 

ture of the credit union industry, and 

the evolving role of credit unions in 

the financial marketplace. 

The credit union industry in the 

U.S. has undergone vast changes in 

the past two decades. Starting that 

period, there were approximately 

24,000 credit unions in operation, 

with 23 million members, and $18 bil 

lion in assets. Their asset powers gen 

erally were limited to short-term, 

small consumer loans and they had 

restricted membership requirements. 

As of June 30, 1990 the number of 

federally insured credit unions had 

declined to 13,102, of which 8,659 

were federally chartered and 4,443 

were state-chartered. Their member 

ship, however, had grown to about 55 

million, and their assets to almost 

$200 billion. Today's credit unions 

have the authority to offer a wide 

range of consumer credit and deposi 

tory services, and with relaxed mem 

bership requirements. 

The study concludes that while 

credit unions have remained profit 

able and are in better financial condi 

tion than banks and thrifts, 

"difficulties could develop if credit 

unions are not operated safely and 

soundly in their new environment, if 

regulation is not modernized, if super 

vision and failure resolution are not 

timely and effective, and if the Na 

tional Credit Union Share Insurance 

Fund (NCUSIF) is not adequately 

overseen and financed." 

Along with the growth and contin 

ued profitability of the credit union 

industry, it has been exposed to in 

creased risk. The greatest recent 

change in credit unions' asset portfo 

lios, and one with the greatest risk, has 

been increased real-estate lending, 

including first mortgages and homeequity loans. Such lending rose from 

five percent of assets in December 

1985 to 21 percent in June 1990. 

Credit unions may also make "mem 

ber business" loans (commercial 

loans). These loans in mid-1990 to 

taled $1.4 billion (0.7 percent of as 

sets), excluding certain loans, such as 

commercial loans under $25,000, and 

those secured by a primary residence. 

Among the report's recommenda 

tions for maintaining sound insurance 

fund operations are: 1) expanding the 

Board of the NCUA to five members, 

to include the Chairman of the Fed 

eral Reserve Board and the Secretary 

of the Treasury, to be ex ojftcio mem 

bers; 2) require NCUA to identify un 

sound practices and the specific 

enforcement actions that will be used; 

3) require credit unions (including 

"corporate" CUs) to expense their 

one-percent deposit in the NCUSIF 

over a reasonable period of time; and 

4) authorize the NCUA to increase 

the NCUSIF capitalization level and 

the premium percentage above cur 

rent limits and to borrow from the 

Treasury on behalf of NCUSIF. 

To improve regulation and super 

vision, the recommendations include 

in part: 1) require NCUA to establish 

minimum, risk-based capital stan 

dards for credit unions, with a phasein period; 2) limit credit unions' 

single-borrower loans to one percent 

of a lender's total assets, with larger 

limits as appropriate for small credit 

unions; and 3) prohibit natural-person 

credit unions (members are individu 

als, not other CUs) from borrowing, 

except to meet liquidity needs, unless 

56 
Recent Developments 

prior regulatory approval has been ob 

tained. 

The report contains numerous 

other recommendations and though 

not specifically recommended, GAO 

also believes Congress should, at a 

minimum, consider providing guid 

ance on the purpose and limits of the 

common bond requirement, making 

it applicable to all federally insured 

credit unions. Credit Unions, Reformsfor En 

suring Future Soundness, U.S. General Accounting 

Office, July 1991. 

57