Federal Deposit Insurance Corporation 

Acting Ch airm an 

Andrew C Hove, Jr. 

Division of Research 

and Statistics, 

Director 

Wm. Roger Watson 

Bditor 

George E. French 

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r_ 

Fall/Winter 1992 

Vol. 5, No. 2 

Table of Contents 

Bank Failure Resolution, the Cost Test and the Entry and Exit of 

Resources in the Banking Industry 

by Frederick S. Cams and Lynn A. Nejezckkb pagel 

FDIC cost considerations determine the "minimum acceptable bid" for a failed-bank franchise. 

In competitive markets, however, the decision whether to continue operations depends upon 

franchise value alone. Thus, for example, the FDIC's statutory cost test may dictate a purchaseand-assumption transaction, even for an institution with negative franchise value. Using failedbank data, the authors find that the cost test may have interfered with efficient resource 

adjustment in a sizable percentage of recent cases. While this conflict cannot be completely 

avoided, the authors argue that a more explicit consideration of resource-adjustment effects could 

help to strike an appropriate balance between the conflicting policy objectives. 

The Bank Insurance Fund: Trends, Initiatives, and the Road Ahead 

by Panos Konstas page 15 

The changes to the financial condition of the Bank Insurance Fund (BIF) that have occurred over 

the past decade and the recent measures taken to restore the BIF to financial viability are discussed 

in this article. The author recommends that a "moving-average" approach to assessment policy 

be implemented after the BIF reserve reaches its target ratio of 1.25 percent of insured deposits. 

Acquisitions of Fuiled-Bank Deposits: In-Market vs. Out-of-Market 

Cost Effects 

by Neil B. Murphy page 24 

Banks seeking to acquire an insured-deposit franchise from the FDIC establish their bids based 

upon expected net future earnings from the acquisition. Does a high bid from an in-market bank 

reflect cost efficiencies or gains from reducing the number of competitors in the market area? 

Using standard econometric techniques and simulations of specific transactions, the author finds 

that in-market bidders who close redundant branches can achieve substantial cost efficiencies. 

While there may not be economies of scale as a bank expands, there appear to be economies of 

scale as the typical branch expands. 

Recent Developments Affecting Depository Institutions 

by Benjamin B. Christopher page 34 

This regular feature of the FDIC Banhfig Review contains information on regulatory agency actions, 

state legislation and regulation, and articles and studies pertinent to banking and deposit insurance 

issues. 
Bank Failure Resolution 

: e 

the E Exit 

e 

by Frederick S. Garns and Lynn A. Nejezchleb* 

Introduction 

Between year-end 1986 and 1991, 

the FDIC closed or assisted over 900 

commercial banks with assets total 

ling about $170 billion. That amount 

is roughly twice the total failed-bank 

assets handled by the FDIC during 

the previous 53 years of the Agency's 

existence. Stated differently, in just 

five years more than five percent of 

the banking industry's total assets 

moved through the FDIC's failureresolution process. 

With numbers like these, it is little 

wonder that the failure-resolution 

process is receiving considerable at 

tention. Most of this attention has 

focused on the costs of bank failures, 

as reflected in the Bank Insurance 

Fund balance. A number of inter 

ested persons have pointed to closure 

policies that provide defacto insurance 

to uninsured depositors or to the lack 

of timely closures of insolvent insti 

tutions as being primarily responsible 

for high insurance losses. 

Another area of attention concerns 

the effects of the failure-resolution 

process on the remaining financial in 

stitutions. Frequently, banks complain 

that the failure-resolution process cre 

ates unfair competitive advantages for 

the acquirers of failed banks. A few 

studies have looked at the effects of 

the FDIC bidding procedures for failed 

banks on the winning bidders. A 

general question addressed in these 

studies is whether the FDIC's auction 

procedures result in wealth transfers 

from the insurance fund to the ac 

quirers of failed banks. While the 

findings have been mixed, the studies 

suggest that competitive bidding pro 

cedures would ensure that the FDIC 

receives the highest revenues and, at 

the same time, would eliminate pos 

sible subsidies to the acquirers of failed 

banks, thereby eliminating any unfair 

advantages over surviving competitors. 

These two aspects of failure reso 

lution — the cost of failures to the 

insurance fund and their effect on the 

acquirers and remaining market par 

ticipants are two sides of the same 

coin. The sale of a failed-bank fran 

chise has implications for both the 

insurance fund and the remaining 

financial institutions in the affected 

market. 

The sale of any failed firm's 

franchise is the result of an interaction 

between sellers and buyers. The sale 

of a failed-bank franchise, however, 

involves a unique restriction on the 

seller. The minimum price the FDIC 

will accept must meet a statutory cost 

test. The cost test requires that the 

minimum acceptable bid be such that 

the cost of a franchise sale is less than 

the cost the FDIC would incur if it 

paid off only the insured deposits and 

liquidated the assets itself. 

"The authors are Senior Economise in the 

Division of Research and Statistics and Special 

Assistant to the Vice Chairman of the FDIC, 

respectively. The authors thank Thomas Yeans 

for expert research assistance and John Bovcn

21, Gary Fissel, George Ftench, Alton Gilbert, 

Eric Hirschhorn, Arthur Murton, participants in 

the Office of Thrift Supervision's Seminar Series 

and the staff of the FDIC's Division of Re 

search and Statistics for valuable comments and 

suggestions. An earlier version of this paper was 

presented at the Federal Reserve Bank of Chi 

cago's 1992 Conference on Bank Structure and 

Competition. 

For example, in an American Banker article 

this was referred [o as a "survivor's hell." See 

"Recapitalizing Failed Banks Creates a 'Sur 

vivor's Hell'," American Banker, 3 January 1991, 

p. 4. Also see "FDIC's Hospital Plan a Bitter 

Pill for Some," The Washington Pan, 1 March 

1992, p. HI. 

See, for example, Christopher James and 

Peggy Wier (1987), and John O'Keefe (1992). 

' In addition, the FDIC Improvement Act of 

1991 (FDICIA) introduced an additional re 

quirement. A sale of the failed-bank franchise 

must nor only be less expensive than a payoff, 

it must also be the least expensive rype of 

franchise sale. See Footnote 4 for a more com 

plete explanation. 
FDIC Banking Review 

In calculating the minimum acceptable bid, the FDIC must estimate the costs 

of liquidation and the losses that would be borne by uninsured depositors if the 

institution were paid off and liquidated. But, in bidding for a failed-bank fran 

chise, neither the FDIC*s liquidation costs nor the distribution of losses between 

the uninsured depositors and the FDIC are a direct concern to potential acquirers. 

Instead, bidders are concerned with the failed bank's potential franchise value, 

i.e., its potential income stream relative to market returns. 

This study argues that the FDIC's statutory cost test may encourage the 

acquisition of failed banks with negative franchise value and may discourage the 

acquisition of failed banks with positive franchise value. If the FDIC estimates 

that its liquidation costs are high under a payoff scenario, high relative to the costs 

an acquirer would incur if the assets were resolved in the acquired institution and 

high relative to the losses that would be shared with uninsured depositors, then 

cost considerations may cause the FDIC to subsidize the acquisition of a nega 

tively valued franchise in order to avoid its potential liquidation costs. On the 

other hand, if the losses that would be shared with uninsured depositors are large 

relative to any cost differences between the FDIC and a potential acquirer, then 

the FDIC may require a minimum bid that acts as a tax on a positively valued, 

failed-bank franchise. As a result of these cost considerations in handling failure 

resolutions, adjustments in particular banking markets to over- or underbanking 

may be impeded. In effect, this study argues that there is an inherent conflict 

between the two policy objectives of minimizing costs to the FDIC under the 

statutory cost test and efficient resource adjustments in banking markets to overor underbanking. 

Moreover, competitive bidding procedures do not eliminate the problem as 

sociated with a potential subsidy. Competitive bidding only ensures that any subsidy 

is reduced to the point that the combined return from the franchise value and the 

subsidy yields a market rate of return to the acquiring institution. The subsidy, 

nonetheless, permits the continued employment of banking resources that would 

otherwise exit the industry. 

Cost Test and Franchise Value 

The source of the conflict discussed above arises because the FDIC and the 

"market" use different decision rules to determine whether a failed-bank 

franchise continues or expires. Whereas the FDIC's decision whether to sell a 

failed franchise or liquidate the franchise is based on a statutory cost test, potential 

acquirers of failed banks xare primarily interested in the failed entity's franchise 

value as a going concern, i.e., the future income stream that results from the 

acquisition. We will refer to this as the market's decision rule. In this section, we 

will develop these two decision rules and describe the potential conflicts between 

the cost test and efficient resource adjustments in banking markets. 

The FDIC's Decision Rule 

In order for the FDIC to sell a failed-bank franchise (or provide open-bank 

assistance), the transaction must meet a statutory cost test which requires that it 

be less costly than paying off the deposits and liquidating the bank's assets (a 

payoff). The cost of a payoff to the FDIC is: 

(1) Cost of Payoff = <GC + LIQ) [-(GC + LIQ) x UINS]; 

where GC<0, LIQ<0 and: 

GC'is the imbedded loss or going-concern deficit; it is the value of the failed 

bank's assets and liabilities after adjusting (a "mark-to-market") for interestrace movements and creditquality problems on a goingconcern basis. GC is not 

observable directly from the 

bank's financial statement; it 

will be derived based on as 

sumptions concerning LIQ; 

LIQ is the "liquidation differ 

ential," that is, the decrease in 

value (if any) of the bank's as 

sets and liabilities that results 

from liquidating them, rather 

than leaving them in a going 

concern; and 

UINS is the proportion of total 

deposits that is uninsured, 

Equation (1) states that the cost of 

a payoff to the FDIC is equal to the 

sum of the going-concern deficit and 

the liquidation differential (the nega 

tive values of GC and LIQ are trans 

lated into costs with the negative 

sign), less the amount of losses borne 

by uninsured depositors. The sum of 

the two cost components, GC and 

LIQ, is equal to the total loss in the 

bank that would occur in a liquidation 

scenario. While the total loss is es 

timated in an actual failure situation, 

it is difficult to determine the dis 

tribution of loss between these two 

FD1CIA adds a new requirement. It re 

quires that the PDIC choose the least costly 

transaction. For example, if two different types 

uf franchise sales are both less expensive than 

a payoff, the FDIC will be required to choose 

the sale option that is least expensive. One 

option might be to sell all the assets and transfer 

all deposits (including uninsured) co an acquirer. 

Another option might be to sell all the assets 

and only transfer the insured deposits to an 

acquirer. Under the old rule, the FDIC was free 

to choose either sale option in this example, 

provided both were less expensive than a payoff. 

Under the new rule, the FDIC must choose the 

least costly approach. However, under either 

rule, the payoff is still the baseline upon which 

to decide whether there wil I be a payoff or some 

form of a franchise sale. 

To simplify the discussion, it is assumed 

that all liabilities are deposits. 
Bank Failure Resolurion 

components (and, in fact, the FDIC 

does not do so). Subsequently in this 

study various assumptions regarding 

LIQ will be specified in order to 

make some judgments about poten 

tial conflicts. 

The liquidation differential may 

reflect two kinds of losses in value 

chat result from liquidating a failed 

bank. One type of loss is unavoidable; 

the other is potentially avoidable. 

The unavoidable loss in value results 

from disruption of the borrowerlender relationship which occurs in a 

liquidation. Many mid- and lowerlevel staff of the failed bank, who have 

information and expertise on loan cus 

tomers and who ordinarily would be 

retained by new ownership, may not 

be present under a liquidation 

scenario. This information and staff 

expertise, when combined with a 

going-concern context where loan 

restructurings and credit extensions 

are an integral part of the business, 

may enhance returns above those that 

could be obtained in a liquidation. In 

addition, loan customers may be less 

cooperative in a liquidation scenario 

because a banking relationship is no 

longer at stake. The unavoidable 

component occurs regardless of the 

efficiency of the liquidator and 

^"he term "franchise sale" in this study 

denotes a hypothetical transaction where the 

failed-bank franchise is sold to an acquirer who 

is compensated for the going-concern deficit 

and who is required to inject capital into the 

failed bank so as to bring the level up to the 

minimum, regulatory capital requirement. In 

this hypothetical transaction, it is also assumed 

that the FDIC and the acquirer both know and 

agree on the amount of the going-concern deiicit. 

This hypothetical franchise sale most closely 

resembles an actual whole-bank transaction, in 

which nearly all of the failed bank's assets and 

liabilities are sold to an acquiring bank. How 

ever, the conclusions that follow from the hypo 

thetical franchise sale are also applicable, but to 

a lesser extent, to transactions in which fewer 

assets are sold to the acquirer, i.e., purchase

and-assumption transactions. The actual struc 

ture of failed-bank transactions is discussed later. 

The term "premium" is used here to refer 

to the potential acquirer's estimate of franchise 

value. The term "bid" is used more generally 

to refer to the total amount the acquirer will payto or receive from the FDIC. For example, if 

acquirers must estimate GC and include that 

amount in their bid, then the bid is the sum of 

the GC and the premium. 

reflects the information-intensive nature of banking assets. 

The other type of loss in value that may be represented in the liquidation 

differential is potentially avoidable. This loss in value represents any difference 

in efficiency in liquidating assets between the public and private sectors. In 

addressing questions concerning collections, loan restructurings, foreclosures and 

other legal actions, an acquiring institution may face fewer constraints and have 

stronger financial incentives to pursue least-cost solutions than does the FDIC. 

Thus, an acquiring institution may be able to liquidate problem assets more 

efficiently than the FDIC. 

An alternative to a payoff and FDIC liquidation is to sell the failed-bank 

franchise. The cost of a franchise sale where all of rhe depositors of the failed 

institution are made whole is: 

(2) Cost of Franchise Sale = GC Premium; 

where Premium is the amount the potential acquirer is willing to pay for a failed 

bank after having been compensated for the going-concern deficit (GC) and after 

the potential acquirer has adequately capitalized the new bank. The premium is 

the bidder's estimate of the failed bank's franchise value. 

Equation (2) states that the FDIC's cost of a franchise sale is equal to the 

amount of money needed to compensate the acquirer for the going-concern 

deficit, less any premium paid to the FDIC by the acquiring bank. No loss-sharing 

by uninsured depositors is included because it is assumed that, in this case, the 

transaction makes all depositors whole. 

If uninsured depositors share losses with the FDIC in a franchise sale (i.e., the 

acquirer does not assume the uninsured deposits), then the cost becomes: 

Cost of Franchise Sale with prorata Loss 

(3) = GC [-(GC + Premium) x UINS] Premium. 

The second term, [-{GC + Premium) x UINS], represents the losses borne by the 

uninsured depositors given the acquirer's bid for the franchise. 

The definitions of GC, LIQ, and Franchise Value are illustrated by the 

example of a failed bank in Chart 1. In the left-hand T-account, the bank has 

been declared insolvent because its regulatory capital (book equity) has been 

depleted. However, when its assets and liabilities are marked-to-market for 

interest-rate movements and credit-quality problems (the "mark" or GC in the 

T-accounts) and when we take into account that the assets are worth less in a 

liquidation than in a going concern (LIQ), the liquidation value of the failed bank 

is a negative $20. Franchise value is not considered in either the book or 

liquidation T-accounts. Franchise values, such as core deposits, customer loyalty, 

or other attributes that give this franchise some ability to earn above-market 

returns (below-market returns in the case of a negatively valued franchise), are not 

considered when determining regulatory capital and are of no value in a liquidation. 

The going-concern value is shown in the third T-account. The going-concern 

value is equal to the sum of the going-concern deficit (or, again, the "mark") and 

any franchise value. That is, the going-concern value is the total market value of 

the bank (GC + Franchise Value) evaluated on a going-concern basis. In this 

example, the going-concern value is a negative $12, compared to a liquidation 

value of a negative $20. 

Chart 1 

Failed-Bank Example 

Liquidation Going-Concern 

Book Value Value Value 
FDIC Banking Review 

The Cost Test or FDIC Decision Rule.ln order to accept a franchise sale, it must 

be less costly to the FDIC than a payoff. Thus, when all uninsured depositors are 

made whole in a franchise sale the rule concerning the minimum acceptable 

premium is: 

Cost of Franchise Sale < Cost of Payoff; 

GC Premium < -(GC + LIQ) [-(GG + LIQ) x UINS]; 

or 

(4) Premium > LIQ + [-(GC + LIQ) x UINS]. 

Equation (4) states that in order for a bid to be accepted the premium must be 

greater than the liquidation differential plus the costs shared by the uninsured 

depositors. Since LIQ is negative, the required premium could also be negative 

where the absolute value of LIQ is greater than [-(GC + LIQ) x UINS]. In other 

words, the cost test could require the FDIC to compensate an acquirer for the 

going-concern deficit and pay additional funds in order to avoid costs associated 

with the liquidation differential. From (4), the factors that determine the mini 

mum required premium are the size of the going-concern deficit, the proportion 

of deposits that is uninsured, and the size of the liquidation differential. 

In cases where uninsured depositors incur pro rata losses in a franchise sale, 

the rule concerning the minimum acceptable premium would be: 

Cost of Franchise Sale with pro rata Loss < Cost of Payoff; 

-GC [-(GC + Premium) x UINS] Premium 

< (GC + LIQ) [-(GC + LIQ) x UINS]; 

or 

(5) Premium > LIQ. 

In other words, when the uninsured depositors share in the losses in a franchise 

sale, just as they do in a payoff, the required premium to meet the cost test must 

be greater than the liquidation differential. Here again, since LIQ is negative, a 

negative premium would be acceptable to effect a transaction. That is, after 

compensating an acquirer for the going-concern deficit, the FDIC would be 

willing to pay an acquirer additional funds up to the costs associated with the 

liquidation differential in order to avoid them. 

requirement under the least-cost rule is that, in addition to being less costly 

than a payoff, the franchise sale must be the least costly of all franchise-sale 

options. In the two cases just presented, if the uninsured depositors are to be made 

whole in a franchise sale (versus not making them whole in a franchise sale) the 

purchaser must be willing to pay an additional premium to acquire the uninsured, 

such that the FDIC is compensated for the losses the uninsured would otherwise 

bear. 

Market's Decision Rule to Continue Franchise 

Unlike the FDIC, a market participant is not concerned about the relative 

share of losses borne by uninsured depositors and the FDIC or the value of 

banking assets outside a going concern, Rather, the participant is concerned 

about the bank's franchise value. 

In bidding on a failed institution a market participant is faced with the 

following hypothetical situation: The FDIC has agreed to eliminate the failed 

institution's going-concern deficit by compensating the acquiring institution in 

some fashion. The winning bidder will be required to capitalize the bank to bring 

it up to the minimum, regulatory capi 

tal requirements. Given this situation, 

what premium would a market par 

ticipant be willing to bid? 

Obviously, the premium would de 

pend on the future income stream 

which the potential acquirer expected 

to receive from the capital investment. 

If the potential acquirer expected to 

receive above-market returns on the 

required capital investment, the pre 

mium would be positive. If belowmarket returns were expected, the 

premium would be negative. Expec 

tations of normal returns would elicit 

a premium of zero, i.e., the potential 

acquirer would only be willing to put 

up the required capital investment. 

Conflict Between Cost Test 

and Efficient Entry and 

Exit 

The cost test currently employed 

by the FDIC, on the other hand, has 

the potential to distort this outcome. 

Uneconomic decisions may be encour 

aged or forced because the FDIC 

would be willing to accept negative 

premiums in cases where the costs 

associated with the liquidation dif 

ferential are high or would require 

positive premiums in excess of the 

franchise value where a large propor 

tion of total deposits is uninsured. In 

the former case (where negative pre 

miums are acceptable minimum bids), 

too many resources may continue to 

be devoted to banking. In the latter 

case {where positive premiums in ex 

cess of franchise value would be re 

quired), too few resources would be 

devoted to banking. 

The conflict between the FDIC's 

cost test and the efficient employment 

During the fust four months of \99Z, ac 

quirers were willing to pay an additional pre 

mium to cover the uninsured in over 50 percent 

of the cases in which a failed bank was acquired. 

This presumes that che participant plans to 

operate the franchise as a going concern. 
Bank Failure Resolution 

of resources in banking markets oc 

curs in the following situations: 

/. The highest bid passes the FD/C's 

cost test, but thefranchise value is nega 

tive. This could occur where: the mini 

mum acceptablepremium [see Equation 

(4) or (5)]< franchise <0. In situations 

where the franchise value is less 

than zero and the minimum accept 

able premium is less than the fran 

chise value, the franchise could still 

be sold and excess resources would 

continue to be employed in this 

particular market. The transaction 

would make sense from the FDIC's 

perspective where the FDIC's costs 

associated with the liquidation dif 

ferential are high and the losses 

shared with the uninsured depos 

itors are relatively low. In this case, 

in addition to compensating the ac 

quirer for the GC deficit the FDIC 

would be willing to pay the ac 

quirer additional funds in order to 

avoid costs associated with the liq 

uidation differential. This may 

result in excess resources continu 

ing to be employed in this par 

ticular market. 

2. The highest bid fails the cost test, but 

the franchise value is positive. This 

could occur where: the minimum ac 

ceptable premium [see Equation (4) or 

(5)J > franchise > 0 and where the 

positive franchise value derives from 

the uninsured deposits. In situations 

where the failing institution has a 

positive franchise value but the min 

imum acceptable premium is greater 

than the franchise value, the fran 

chise would not be awarded to a 

bidder, assuming no one would offer 

a premium worth more than the fran 

chise value. Yet, from an economic 

perspective it would be desirable 

to continue to employ the resources 

of the failed bank in this particular 

market. This situation could occur 

where the losses shared by the unin 

sured depositors in a liquidation 

(payoff) were large relative to the 

FDIC's costs associated with the 

liquidation differential and where 

the positive franchise value derives 

from the uninsured deposits. 

While it makes sense from the 

FDIC's perspective to liquidate or 

pay off the failed bank, the exist 

ence of a positive franchise value is 

evidence that consumers would ben 

efit if those resources could contin 

ue to be employed in this market. 

With regard to the first case, it is 

legitimate to ask why an acquirer would 

choose to operate a negatively valued 

franchise as a going concern. Why not 

pocket the FDIC subsidy and liquidate 

the losing franchise? One plausible 

explanation involves managerial incen 

tives and the so-called "agency prob 

lem" in the relationship between 

managers and owners. For various rea 

sons, stockholders may have difficulty 

in directing managers to maximize the 

long-run value of firm shares. Often, 

managerial compensation and career 

prospects are tied more closely to firm 

size and short-run financial perfor 

mance. Thus, managers may favor a 

going-concern mode for the acquired 

franchise even if this does not maxi 

mize long-run returns to shareholders. 

Another possibility is that managers 

do not view franchise value as fixed or 

wholly beyond their control. In some 

cases, managers may envision chan 

ges in operating strategy or other firm 

characteristics that could enhance the 

acquired bank's franchise value. 

The point is not that all acquirers 

will necessarily operate negativelyvalued franchises as going concerns. If 

some acquirers are more efficient li 

quidators than the FDIC, they may 

purchase failed-bank franchises merely 

to liquidate them, pocketing the dif 

ference between their own liquida 

tion costs and those of the FDIC. ' Or 

an acquirer may purchase a franchise 

and avoid liquidation costs altogether 

by simply winding down the opera 

tions of the acquired bank. Though 

we observe such outcomes in few, if 

any, failed-bank acquisitions, they are 

nevertheless possibilities. Our point 

is only that plausible reasons exist for 

acquirers to operate negativelyvalued franchises as going concerns, 

thus retaining excess resources in cer 

tain banking markets. 

Cost Test in Practice 

In small-bank resolutions, franchise 

sales run along a continuum from the 

sale of nearly all of a failed bank's 

assets and liabilities (whole-bank trans 

action), to the sale of the liabilities and 

only the highest-quality assets (clean 

purchase-and-assumption transaction). 

The terms of large-bank transactions 

tend to be less uniform and are not 

as neatly categorized as small-bank 

transactions. 

In a whole-bank transaction, 

potential acquirers are bidding for the 

right to assume the failed bank's de 

posit liabilities and purchase all of the 

bank's assets. Potential acquirers are 

given the opportunity to perform asset 

reviews on the failing institution in 

order to estimate the institution's 

Under the least-cost rule, acquirers have 

the option not to take the uninsured deposits if 

they are unwilling to pay an incremental pre 

mium that would cover the uninsured depositors' 

loss-sharing. Thus, under the new least-cost 

rule, the only situation in which the cost test 

would prevent a positively valued franchise 

from being acquired would be when the posi 

tive franchise value derives from the uninsured 

deposits and, yet, the amount the acquirer must 

pay to make up for the FDIC's foregone losssharing is greater than the positive franchise 

value. It is likely that this situation would occur 

in only a limited number of cases. Prior to the 

least-cost rule, however, acquirers did not have 

the option to take only the insured deposits in 

a franchise sale, [f the loss-sharing was large 

relative to the liquidation differential and the 

premium was insufficient to cover the loss-shar 

ing, then the failed bank would be paid off. Our 

analysis of potential conflicts (depicted in Chart 

3) was based on failed-bank data prior to the 

implementation of the least-cost rule, a period 

when the potential for this particular conflict 

was greater than it now is. 

It could be argued that the first conflict 

(MAP<Franchise<0} is more serious than the 

second conflict (MAP>Franchise>Q). In the 

second situation, other operating institutions 

could expand their operations to meet the bank 

ing needs of the new bankless consumers or a 

new bank could be chartered. However, in the 

First situation (MAP < Franchise ; 0), the sub 

sidized employment of excess resources will 

have detrimental effects on other industry par 

ticipants for some time to come. This will im 

pose losses on other industry participants, 

which could eventually threaten their solvency 

and, thereby, impose future losses on the in 

surance fund. 

1 See Jensen and Meckling (1976) and Gor 

ton and Rosen (1992). 

"This point is attributable to AJron Gilbert. 
FDIC Banking Review 

going-concern deficit (GC, the same definition as used in Equation (1)) and its franchise value (Premium). Thus, a bid for a 

whole bank is: 

(6) Bid = GC +Premium. 

Since the going-concern deficit is normally large relative to the premium, the bid on a whole-bank transaction is normally 

negative, i.e., the bidders are stating the amount of cash the FDIC must pay them to take over the failed bank's assets and 

liabilities. 

In calculating the minimum acceptable bid for a whole-bank transaction, the FDIC conducts an on-site review of the 

failed bank to determine its resolution cost. This cost is an estimate of the total loss in the bank if it were liquidated by the 

FDIC, less any losses borne by the uninsured depositors. 

Using the terminology developed in this study, the minimum acceptable bid (MAB) in a whole-bank transaction is: 

(7) MAB = (GC + LIQ) [(GC + LIQ) x UINS], 

Since the bid must be greater than the MAB, the cost test for a whole-bank transaction is: 

Bid > MAB; 

(8) GC + Premium > (GC + LIQ) [(GC + LIQ) x UINS], 

if the uninsured deposits are acquired and made whole; 

or 

(8.1) GC +■ Premium > GC + LIQ, 

if the acquirer elects not to take the uninsured deposits. 

In the following section, information on whole-bank transactions is utilized to make inferences about the effect of the 

FDIC's decision rule on the efficient entry and exit of resources from banking markets. The analysis was limited to 

whole-bank transactions because of the difficulties in drawing inferences about franchise value in other types of transactions. 

For example, the use of putbacks, loss-sharing provisions and extensive replacement of bank assets with cash make it difficult 

to infer franchise value from bid information. 

Evidence From Whale-Bank Bids 

Methodology 

Ideally, the goal would be to locate evidence indicating whether FDIC resolution decisions have interfered with efficient 

exit and/or entry in banking markets; but because good estimates are unavailable for market-determined franchise values 

and for the FDIC's liquidation differential, the evidence will of necessity be circumstantial. While it cannot be determined 

with confidence whether banking resources were actually misallocated as a result of past resolutions, the FDIC's cost-test 

calculations and whole-bank bids received by the FDIC may contain certain clues that are suggestive. 

The FDIC makes resolution decisions on the basis of its own estimates of loss in a failed bank. As noted in Equation (1), 

this estimated loss may be viewed as having two components: the going-concern deficit, GC (going-concern losses imbedded 

in failed-bank assets), and the liquidation differential, LIQ. Given certain bold assumptions, a measure of GC may be 

extracted from FDIC data and an implied franchise value for the failed institution may then be derived by netting GC from 

whole-bank bids. 

To be more explicit, our approach is to make "reasonable" assumptions about the value of LIQ and then solve Equation 

(7) to determine the size of the implied GC. For the "minimum acceptable bid" (MAB) and the "uninsured liabilities" 

(UINS) in Equation (7), we use the actual values presented to the FDIC Board in each case. Given an assumption about 

LIQ, GC is easily inferred. We use four alternative assumptions about the size of LIQ to obtain a range of plausible values 

for GC in each case. Next, assuming that bidders use these same estimates of the going-concern deficit in making their bids, 

we deduct GC from the winning (or highest) bid in Equation (6) to reveal the imbedded premium, our estimate of franchise 

value (four estimates for each case). 

Finally, we use the estimates of franchise value to observe whether any positively valued franchises were extinguished 

{i.e., whole-bank bids with positive premiums were rejected) or any negatively valued franchises were preserved {i.e., 

'^Because acquirers generally did not purchase [he whole bank and leave che uninsured deposits behind prior to FDICIA, Equation (8) is relevant for 

the subsequent analysis. 
Bank Failure Resolution 

whole-bank bids with negative premiums were accepted). For example, suppose 

a particular failed-bank case shows the following: 

Total Assets Total Uninsured MAB Highest Bid 

(book) Liab. Liab. Received 

$21.3MM $20MM $200M -$5MM -$4MM 

Suppose also that LIQ=.O8 x (total assets) which, in this case, is equal to -$1.7MM. 

Then using Equation (7) we get: 

-5MM = (GC 1.7MM) [(GC 1.7MM) x (2O0M/2OMM)]; 

GC = -$3.35MM. 

Substituting this value into Equation (6) produces: 

-$4MM = -$3.35MM + Premium; 

Premium = -$650M. 

In this hypothetical case, the FDIC would accept the bid because it exceeds 

MAB, but our methods show a derived franchise value that is negative. 

Given the heroic assumptions necessary for this exercise and the resulting 

potential for large measurement errors, an estimated premium that is only mar 

ginally negative (and accepted) or marginally positive (and rejected) probably 

should not be viewed as credible evidence of anything. Some indicator of eco 

nomic "significance" is required for a duly cautious interpretation of results. We 

scale the estimated premiums by bank asset size and consider certain ad hoc 

thresholds (e.g., one or two percent of total assets) that might permit a reasonably 

secure inference. In the example above, the negative premium exceeds three 

percent of total assets, which seems substantial. 

This implied franchise value may be "incorrect" {i.e., it may differ from the 

bidder's estimate of franchise value, which is unobservable), and so we cannot 

know whether a given resolution actually interfered with economic efficiency. 

It might be argued that bidders1 estimates of the going-concern deficit are likely 

to be larger than indicated in this exercise. Bidders may have less information 

about borrowers and loan quality than does the FDIC. Given this, the bidders 

may use higher discount rates than those implied here in valuing future return 

streams from existing failed-bank assets. If so, this analysis will underestimate the 

deficit componentand overestimate the premium component ofwhole-bank bids. 

For example, in cases where negative whole-bank bids are accepted, the meth 

odology may indicate negative premiums when the franchise value as perceived 

by bidders is actually positive. It could be the case that the bidder's estimate of 

GC is lower (more negative) than the FDIC's by such an amount that, when the 

FDIC's GC is deducted from the whole-bank bid [Equation (6)], this gives the 

false appearance of a negative premium. We can never be sure whether the 

method is simply mistaking the difference between the bidder's GC and the 

FDIC's GC for a negative franchise value. 

There is no avoiding this problem and, as indicated above, this is one reason 

we cannot determine whether past resolutions actually interfered with efficiency. 

Despite this limitation of the methodology, we maintain that a persistent finding 

of significant negative premiums on accepted bids would have important implica 

tions. If the premiums in these cases reflect actual franchise values, then the 

conflict between the cost test and efficiency becomes more explicit via our 

calculations. The findings then provide some basis for a deliberate weighing of 

stakes in the trade-off between cost-saving and market efficiency. 

On the other hand, if the premiums merely reflect large differences in GC 

estimates used implicitly by the FDIC and private bidders, this may indicate a 

potential for large gains by narrowing such differences. If the FDIC is believed 

to have better information and thus a 

more accurate estimate of GC, then 

perhaps FDIC costs could be lowered 

through information-sharing. With bet 

ter information made available to bid 

ders, uncertainty could be reduced and 

banking assets may be discounted less 

heavily in the bidding process. For 

many bids, this may spell the differ 

ence between failing or passing the 

cost test and, perhaps, becoming the 

least-cost resolution. Moreover, fewer 

positively valued franchises would be 

extinguished. Conversely, if private 

estimates of GC are closer to the mark 

[bidders are more appropriately dis 

counting banking assets given market 

uncertainties), this implies that the 

FDIC may be rejecting whole-bank 

bids that would both reduce FDIC 

costs and preserve positively-valued 

franchises. Clearly, some effort to 

adjust FDIC estimates would be indi 

cated in this event. 

In short, a finding that negative 

premiums are often accepted, or posi 

tive premiums are often rejected, may 

be interesting and important even if 

1 When whole-bank bids with positive 

premiums are rejected, the failed bank is not 

necessarily resolved with a liquidation and pay 

off. It may be resolved with a P&A or a deposit 

transfer, and some of the franchise value may, 

thus, be preserved. We refer to the original, 

whole-bank franchise as being "extinguished" 

since it is not preserved in its original form, but 

this does not necessarily mean that all franchise 

value is lost. 

16The bidder's estimate, if observable, would 

be a proxy for the market-determined (effi 

cient) price of the franchise. Yet, problems with 

this measure would remain: The so-called "win 

ner's curse," as well as other forms of strategic 

behavior, and a host of potential problems posed 

by inefficient auction processes suggest chac 

bids may reflect more than purely objective 

valuations. 

For example, suppose the highest bidder 

estimates that GC = -$I0MM and includes a 

premium of +$3MM, so that the best wholebank bid is -$7MM. If the implied FDIC es 

timate of GC is -$5MM and the MAB = -$6MM, 

the FDIC will reject the bid. Suppose the fail 

ure is resolved with a payoff and liquidation. If 

it turns out that the bidder's estimate is more 

accurate and the true GC is roughly -$1GMM, 

the payoff and liquidation will cose the FDIC 

far more than the $7M whole-bank sale. More 

over, a franchise with positive value will be 

extinguished with the liquidation. 
FD1C Banking Review 

these "premiums" do not represent 

true franchise values. Moreover, we 

believe the view provided by our 

methods may help to frame some proper 

questions, even if it fails to reveal any 

conclusive answers. 

Data and Findings 

The sample consists of 90 recently 

failed banks for which whole-bank bids 

were received. The easily accessible 

data for failed-bank cases are consis 

tent only from December 1989 going 

forward, so we examined all failedbank cases from December 1989 

through December 1990, the latest 

date for which reliable data were 

available. After deleting cases which 

contained obvious errors or inconsis 

tencies that could not readily be ex 

plained, the result was 45 cases in 

which whole-bank bids were accep 

ted and 45 cases in which all such bids 

were rejected. 

Most of the failed banks in the 

sample are small, under $100 MM in 

assets. The largest bank in the sam 

ple shows assets of $1.6 billion, and 

the average asset size is $94.2MM. 

The size distribution is as follows: 

Asset Size Number of Banks 

As noted earlier, an assumption 

about the liquidation differential (LIQ) 

is necessary to generate franchise 

values from our data. The larger the 

assumed liquidation differential, the 

smaller will be the portion of the 

FDIC's loss attributed to the goingconcern deficit. In turn, the smaller 

the portion of any bid that can be 

attributed to the need to compensate 

the acquirer for the going-concern de 

ficit, the more likely that the cash 

payment demanded of the FDIC must 

be attributed either to a negative fran 

chise value or a risk premium. In ef 

fect, the higher the assumed value of 

LIQ, the greater the bias toward find 

ing negative franchise values. For this 

reason, we use what we believe are 

conservative assumptions concerning 

the size of LIQ. 

There is little evidence on which 

to base any assumption about the value 

of LIQ. In the past, officials at bank 

regulatory agencies have stated 

publicly that bank assets lose about 

ten percent of their value when they 

are removed from a going concern. In 

the spirit of being conservative, we 

opted for LIQ=.O5 x (TOTAL AS 

SETS) as a first assumption. To pro 

vide further assurance that any 

interesting results are not due to an 

exaggeration of LIQ, we chose the 

value of LIQ=.O1 x (TOTAL AS 

SETS) as a more conservative second 

case to be examined. The other two 

assumptions represent LIQ as a frac 

tion of the FDIC-estimated total loss 

in the failed bank (GC+LIQ). One 

rule of thumb mentioned occasionally 

is that liquidation costs account for 

roughly one quarter of the total es 

timated loss in the average failed bank. 

Our third assumption is then LIQ=.25 

x (GC+LIQ). Finally, we examine the 

data using LIQ=.O8 x (GC+LIQ) as 

another conservative assumption. The 

figure .08 was chosen arbitrarily. 

Franchise values are derived under 

each of these assumptions and the 

findings are presented in the format 

of Chart 2. Cells II and III are of 

particular interest because they repre 

sent the two situations of conflict be 

tween the cost test and efficient 

resource adjustments in banking 

markets. We construct one figure for 

each LIQ assumption and report the 

number of cases (out of 90) falling into 

each cell. In cells II and III, we also 

indicate the number of cases in which 

the derived franchise value was at 

least one percent of total assets. 

The findings are presented in 

Chart 3, where each of the four sec 

tions (Charts 3.1 through 3.4) reflects 

the results for a particular LIQ assump 

tion. All of the charts show entries in 

both cells II and III, meaning that we 

find negatively-valued franchises 

among the accepted bids and posi 

tively-valued franchises among the 

rejected bids regardless of the assump 

tion concerning LIQ. 

Cell III of the charts shows that, of 

the 45 rejected bids, as few as six 

(Chart 3.1) or as many as 14 (Chart 3.3) 

may have contained positive pre 

miums. The average number of entries 

in cell IIIamongourfiguresisten,and 

nearly all of the derived franchise 

values for these entries exceeded two 

percent of total assets. 

The major finding is the prepon 

derance of negative franchise values 

among accepted whole-bank bids (cell 

II). Chart 3.4 shows the lowest total 

for cell II, with 20 of the 45 accepted 

bids (or 44 percent) having negative 

franchise values. In Chart 3.1, where 

LIQ=.O5 x (total assets), 84 percent of 

the accepted bids include a negative 

franchise value. Moreover, a high per 

centage of the negative values in cell 

II appear "significant" relative to total 

assets. These findings are especially 

interesting if one believes, as we do, 

that all of the LIQ assumptions are 

relatively low. As explained above, if 

we had used higher estimates of LIQ, 

we would have estimated a higher pro 

portion of accepted bids with nega 

tive franchise values. 

Our methods suggest that a major 

ity of the 90 banks in the sample had 

negative franchise values (54 in Chart 

3.4 is the lowest total, and 77 in Chart 

3.1 is the highest). Is it plausible that 

bids were submitted for so many los 

ing franchises? We are reluctant to 

concede that bidders would not bid on 

negatively valued franchises. As our 

earlier discussion makes clear, if in 

herent liquidation costs are large 

enough and there is little opportunity 

for loss-sharing with uninsured cred 

itors, cost considerations may lead the 

FDIC to pay a substantial amount in 

order to avoid a liquidation. 

However, even if one concedes 

that our finding of a large number of 

negatively valued franchises may be 

due to the bidders and the FDIC plac 

ing different values on the going-con 

cern deficit (GC), rather than a true 

indication of the bidders' estimate 
Bank Failure Resolution 

Market 

Decision Rule 

Positive 

Franchise 

Value 

Negative 

Franchise 

Value 

Chart 2 

Cost Test and Franchise Value 

FDIC Decision Rule 

Passes Cose Test: Fails Cost Test: 

Prera > LIQ + Prem< LIQ + 

Loss-sharing Loss-sharing 

I III 

Bids Accepted No Bid 

Accepted 

MAP > Fran. > 0 

II IV 

Bids Accepted No Bid 

MAP< Fran. <C Accepted 

of franchise value, we believe that; the 

results reported in Chart 3 are still 

important. As indicated earlier, if the 

large number of derived negative 

values are symptomatic of the FDIC 

and bidders' systematically placing 

different values on the going-concern 

value of failed-bank assets, then a 

reconciliation of these differences 

could either lower FDIC costs or 

promote efficient resource adjust 

ments, or both. 

For example, in our sample of 

banks if the bidders' estimates of GC 

were larger (more negative) than the 

FDIC's by five percent of total assets, 

then 34 of the 77 negative franchise 

values reported in Chart 3.1 would 

Chart 3 

Failed-Bank Cases in Which Whole-Bank Bids Were Received 12-89 through 12-90 

(90 observations, using highest bid) 

Chart 3.3: LIQ 25% of (GC + LIQ) Chart 3.4: LIQ = 8% of (GC + LIQ) 

Market Market 

Decision FDIC Decision Rule Decision FDIC Decision Rule 

Rule Rule 

Passes Cost Test Fails Cost Test 

Positive 15 Accepted 14 Rejected 

Derived Pos. Franchise Value at 

Franchise least l%ofTA:12;and 

Value a:Jeasc2%ofTA:ll. 
FDIC Banking Review 

carry the wrong sign; that is, the 

bidders' estimates would indicate 

that these 34 franchise values were 

actually positive rather than negative. 

Moreover, assuming the bidders' es 

timates of GC were correct, at least 

five of the 45 rejected deals would 

have been accepted had the FDIC 

used the bidders' estimates of GC. 

Those five failed banks represented 

22 percent of the total assets in the 45 

rejected deals and, had the bids for 

those banks been accepted, up to $1.2 

billion in failed-bank assets may have 

remained in the private sector, rather 

than being placed in the FDIC's liq 

uidation portfolio. 

On the other hand, if we assume 

that the FDIC's estimate of GC were 

the correct one, then substantial 

savings would have resulted if the 

FDIC could have conveyed this infor 

mation to bidders and reduced their 

five percent error to zero. In addition 

to the gains just described for rejected 

bids, improving the acquirers' bids by 

five percent of total assets would have 

reduced the FDIC's costs by $113 

million on the 45 accepted bids. 

Conclusions and Policy 

Implications 

This study identifies a potential 

conflict between the FDIC's statu 

tory cost test and the efficient entry 

and exit of resources in banking mar 

kets. In situations where the FDIC's 

liquidation costs are relatively high, 

cost considerations may cause the 

FDIC to subsidize the acquisition of 

failed banks with negative franchise 

value in order to avoid the high costs 

of liquidation. On the other hand, in 

situations where substantial compen 

sation is required by the FDIC for 

transferring the uninsured deposits in 

whole to the acquiring bank, the cost 

test may prevent the acquisition of 

failed banks with positive franchise 

value. 

An important concept in this paper 

is the "liquidation differential," by 

which we mean the loss in value 

resulting from removing banking as 

sets from a going concern and liquida 

ting them. To the extent that the high 

liquidation costs result solely from 

removing "bankable" assets from a 

going concern, these conflicts be 

tween the cost test and efficient 

resource adjustments in banking 

markets are unavoidable. Moreover, 

competitive bidding procedures only 

ensure that the acquirers do not 

receive above-market returns on their 

capital investment. A subsidy could 

still remain, permitting a market rate 

of return on those banking resources 

that otherwise would have exited the 

industry. 

However, to the extent that the 

liquidation differential arises because 

the public sector liquidates bank as 

sets less efficiently than the private 

sector, one aspect of the conflict is 

potentially avoidable. If these costs 

are not inherent costs associated with 

removing "bankable" assets from a 

going concern, but are avoidable either 

on a going-concern basis or in a liqui 

dation scenario, then there would be 

no rationale for paying an acquirer to 

avoid them. Policies designed to reduce 

such costs would result in fewer con 

flicts between the statutory cost test 

and efficient resource adjustments in 

banking markets. 

Using information on failure 

resolutions where the FDIC received 

bids on whole-bank transactions and 

assuming reasonable liquidation dif 

ferentials, we attempted to identify 

instances in which the cost test im 

peded the efficient entry and exit of 

resources in banking markets. Cir 

cumstantial evidence exists that the 

statutory cost test may have interfered 

with efficient resource adjustment in a 

sizable percentage of recent failedbank transactions. According to the 

estimates in this study, even though 

franchise sales may have minimized 

FDIC costs, banking market efficiency 

would have improved if many of these 

failures had been handled as payoffs. 

These results could be heavily 

biased if potential acquirers discount 

the going-concern value of "bankable'' 

assets more heavily than does the 

FDIC. This could happen if potential 

acquiters attached greater uncertainty 

to the going-concern value than the 

FDIC, so that the acquirers'estimates 

of franchise value were higher than 

those derived in our analysis. We know 

no way of determining the degree tc 

which this may be true. However, 

even if the analysis overstates the ex 

tent of the conflict between the cost 

test and efficient resource adjust 

ments in banking markets, the con 

flict may still occur in a significant 

number of cases. 

The perspective provided by the 

analysis has several policy implications. 

First, the analysis highlights the im 

portance of efforts to minimize liqui 

dation costs. The FDIC's willingness 

to pay to avoid high liquidation costs 

is the fundamental source of the con 

flict between efficient resource ad 

justments and the cost test. 

Other policy implications relate to 

the source of possible errors in our 

derived franchise values. We noted 

that our derived franchise values may 

be in error if acquirers attach greater 

uncertainty to the value of the 

"bankable" assets than does the 

FDIC. This greater uncertainty may 

be due to the acquirers having less 

information than the FDIC on the 

loan portfolio (the FDIC's estimate of 

GC is correct) or it may be due to the 

FDIC inappropriately discounting 

future market developments with 

respect to the value of failed-bank 

assets (the acquirers' estimate of GC 

is correct). Regardless of the reason 

for any difference, reconciling these 

differences would result in more bids 

meeting the cost test, fewer failedbank assets retained by the FDIC, 

and lower FDIC resolution costs. In 

effect, even if one has trouble believ 

ing that so many acquirers were inter 

ested in failed banks with negative 

franchise values, we believe the 

results of this study have important 

implications. 

The major policy implication of 

the analysis is that, to the extent there 

10 
Bank Failure Resolution 

is an inherent or unavoidable liquida 

tion differential, there is an unavoid 

able conflict between the cost test and 

efficient resource adjustments in 

banking markets. A logical question 

is: How do we strike an appropriate 

balance between these conflicting 

policy objectives? We maintain that 

the cost test should be more flexible 

so that regulatory decision-makers can 

consider the effect of a failure resolu 

tion on banking markets, subject to a 

degree of public scrutiny to ensure 

that the regulatory process adheres to 

its public-policy mandates. We doubt 

that there is any way to precisely mea 

sure the costs and benefits of making 

trade-offs between these objectives. 

But we maintain there are instances 

where the costs of not allowing bank 

ing markets to adjust to over- or un

derbanking are large and where the 

savings in insurance costs are relatively 

small. In these cases, economic welfare 

would be better served if the regu 

latory authorities had greater latitude 

to make informed judgments concern 

ing the appropriate trade-off. 

REFERENCES 

Cams, Frederick S. and Lynn A. Nejezchleb. "Bank Failure Resolution, the Cost Test and the Entry 

and Exit of Resources in the Banking Industry." In Federal Reserve Bank ofChicago Proceedings: 

The 2St/i Annual Conference on Bank Structure and Competition, pp. 101-20. Chicago: n.p. 1992. 

Gorton, Gary and Richard Rosen. "Corporate Control, Portfolio Choice, and the Decline of Banking." 

Presented at Office of Thrift Supervision, Seminar, June 3, 1992. 

James, Christopher and Peggy Wier. "An Analysis of FDIC Failed Bank Auctions." JournalofMonetary 

Economics 20 (1987): 141-53. 

Jensen, Michael and William Meckling. "The Theory of the Firm: Managerial Behavior, Agency Costs 

and Ownership Structure." Journal ofFinancial Economics 2> (October 1976): 305-60. 

O'Keefe, John. "Bank Failure Resolutions: Implications for Banking Industry Structure, Conduct and 

Performance." FDIC Banking Review 5 (Spring/Summer 1992): 17-35. 

11 
The data used in our analysis are 

presented in thisappendix.Thereare 

some questions concerning these 

failed-bank data, and all results 

should therefore be interpreted 

cautiously. One issue concerns the 

choice of a proper value to represent 

the winning, and/or highest, wholebank bid in each case. In some cases, 

"whole-bank" is somewhat of a mis 

nomer because all bank assets are not 

necessarily included in the "whole

bank" bid package. Some assets are 

regularly excluded from the bidding, 

but are subsequently purchased by 

the acquirer. Any extra costs in 

curred by the FDIC in the sale of 

these assets are later added to the 

best bid in order to estimate the full 

cost of the sale. This sum is referred 

to as REQUIRED OUTLAY (for 

Winning Bid) in the FDIC data, and 

FDIC Banking Review 

APPENDIX 

Failed-Bank Data 

its value is closer to the actual transac 

tion price than is the reported amount 

of the winning bid. We use RE 

QUIRED OUTLAY in Equation (6). 

The REQUIRED OUTLAY re 

ported for several whole-bank deals 

reflected a cost that was three (or 

more) times larger than that sug 

gested by the MAB. In some cases, 

this implied such a high percentage of 

assets excluded from the bidding that 

"whole-bank deal" seems to mischaracterize these transactions. For 

present purposes, this problem was 

skirted by excluding such cases from 

the sample. 

Zeros in the MAB column typically 

indicate that the bid package ex 

cluded many problem assets, as dis 

cussed above. In these cases, MAB is 

not directly comparable to Best Bid 

(REQ. OUTLAY), and thus the mag 

nitude of the DERIVED PREMIUM 

is negatively biased. However, the 

table shows the correct sign on the 

DERIVED PREMIUM for all such 

cases, and only the sign is relevant for 

our analysis. Zeroes appearing in the 

Highest Bid column occur when the 

bid implies no cash outflow or a nee 

gain (cash inflow) to the FDIC as a 

result of the deal. In some of these 

cases, the DERIVED PREMIUM is 

again biased downward but the sign 

appearing in the table is correct. 

Columns with the word "derived" 

contain data that were based on the 

assumption concerning LIQ (e.g., 

LIQ=.O5 x ASSETS) or derived from 

Equations (6) and (7) as outlined in 

the text. 

12 

14 
The Bank Insurance Fund 

At year-end 1991, the Federal 

Deposit Insurance Corporation's 

_Bank Insurance Fund (BIF) 

recorded a deficit of $7.0 billion. This 

was the first time in its history that the 

Fund's net worth was negative. This 

deficit occurred against a backdrop of 

premium increases for insured institu 

tions, expanded and more intensified 

examination policies by the regulators, 

and far-reaching deposit insurance 

reform legislation. These develop 

ments, coupled with the underlying 

issue of what to do about the Fund 

deficit, not only raise new concerns 

about the viability of the deposit 

insurance system but also pose 

major challenges to the operating 

policies of both the FDIC and in 

sured institutions. 

The present study examines the 

drastic changes to the BIF balance 

sheet and income statement that have 

accurred over the past decade, the 

financial characteristics of the BIF, 

and the measures in place to restore it 

to Financial viability. Congress has des 

ignated a reserve target for the BIF 

which must be attained within a 

specified period. After this target is 

achieved, the FDIC must adjust pre 

miums annually to keep the BIF at or 

above the target ratio. If the BIF ratio 

Trends, Initiatives, 

by Panos Konstas' 

falls below the target, the FDIC must 

either raise premiums to restore the 

proper ratio within one year, or pro 

mulgate a recapitalization schedule 

projected to reach the target ratio 

within 15 years. Specific issues raised 

by these requirements are examined 

in this study. 

Section one of the analysis 

describes the current financial condi 

tion of the BIF, including revenues, 

insurance losses, cash flows, and fund 

liquidity. Section two reviews key pro 

visions in the recent legislation regard 

ing the BIF. Section three evaluates 

the assessment policy required by the 

FDIC Improvement Act of 1991 after 

the BIF has attained the designated 

ratio of 1.25 percent of insured deposits. 

Finally, section four recommends the 

implementation of an alternative, 

moving-average assessment approach 

after the BIF reaches the target ratio. 

Background and Current 

Status of the BIF 

The Financial Institutions Reform, 

Recovery, and Enforcement Act of 

1989 (FIRREA) renamed the FDIC's 

deposit insurance fund as the "Bank 

Insurance Fund." At the same time, 

the FDIC was given responsibility for 

operating two other funds, the Savings 

Association Insurance Fund (SAIF), 

and the FSLIC (Federal Savings and 

Loan Insurance Corporation) Resolu 

tion Fund, which was established to 

wind up the affairs of the former 

FSLIC. The SAIF insures former 

FSLIC-insured institutions as well as 

any new savings and loan associations. 

The ensuing discussion is generally 

limited to the BIF. 

As of December 31, 1991, the BIF 

had assets of $26.4 billion and liabilities 

of $33.4 billion, for a net worth of 

minus $7.0 billion. The BIF decreased 

by $li.O billion during 1991, and ended 

the year with a negative ratio to in 

sured deposits (-0.36 percent) for the 

first time in its history. 

The ratio of the BIF to insured 

deposits has exhibited noticeable 

stability over long stretches of time, 

although the long-term trend general 

ly has been downward. The ratio was 

at its highest levels during the first ten 

"Panos Konstas is a senior economist in the 

FDIC's Division of Research and Statistics. 

Colleagues who generously contributed com 

ments and suggestions to this paper include: 

Richard Brown, Frederick Cams, Benjamin 

Christopher, Gary Fissel, Ceorge French, Jay 

Goiter, Arthur Murron, Lynn Nejezchleb, 

Robert Storch, and Detta Voesar. 

The term "BIF" is used in this article to 

refer to both the Bank Insurance Fund and its 

predecessor before 1989. 

IS 
FD1C Banking Review 

Table 1 

Results from BIF Insurance and Investment Operations, 1981-91 

(Dollars in Millions) 

years of the FDIC's existence, peak 

ing at 1.96 percent in 1941. From the 

mid-1940s to trie late 1960s the ratin 

fluctuated between 1.3 and 1.5 petcent, and hoveted around 1.2 percent 

during the 1970s and early 1980s. It 

was not until the large losses of the late 

1980s that the BIF-to-insured deposits 

tatio declined precipitously. As late as 

1987, the ratio stood well ahove the 

one percent mark. 

Income and Insurance Losses 

Assessments. The BIF's assessment 

income in 1991 was $5,160 million 

[see Table 1). This amount constituted 

89.1 percent of the BIF's total income 

versus 74.4 percent in 1990. The in 

crease was largely the result of chan 

ges in the assessment rate. This rate 

was raised to 12 basis points ($0.12 per 

$100 of deposits) in 1990 from its 

longstanding level of 8.33 basis points. 

The rate was raised to 19.5 basis points 

for the first half of 1991 and to 23 basis 

points during the second half. 

Interest on U.S. Securities. Section 13 

of the Federal Deposit Insurance (FDI) 

Act provides that FDIC monies not 

otherwise employed shall be invested 

in obligations of the United States or 

in obligations guaranteed as to prin 

cipal and interest by the United States. 

In 1991, the FDIC received $471 mil 

lion in interest income on its portfolio 

of Treasury securities, representing 

just over eight percent of the BIF's 

total annual revenue. A much lower 

proportion of total revenue is now de 

rived from investments than in the 

earjy 1980s due to the decline in the 

FDIC's holdings of Treasury secur 

ities. In 1981, for example, 51 percent 

of total FDIC revenue came from in 

vestments. "Other" income of $15S 

million, representing mainly returns 

on assets from failed and assisted in 

stitutions, constituted the remainder 

of the on-assessment revenue in 1991. 

Losses. Insurance losses, amounting 

to less than $1 billion per year in 1981

1983, more than doubled in 1984 tc 

surpass assessment income. In 1988, 

insurance losses rose to $7.4 billion — 

mote than double the 1987 level and 

four times the 1985 level. For the first 

time in its history the FDIC ex 

perienced a net operating loss for the 

year. In 1991, insurance losses rose to 

$16.6 billion a record high. 

Balance-Sheet Changes 

Assets. In 1981, 92.4 percent of the 

BIF's assets consisted of U.S. Treasury 

securities, including small amounts of 

cash, as shown in Table 2. Ten years 

later this figure had dropped to 19.3 

percent. During the same interval, assets 

•Includes accrued inieresr receivable on assets-and the value of property and buildings. 

"•Includes mainly accounts puyabIcb accrued liabilities, and estimated losses from liligaiton, depositors' claims unpaid, and Funds hctd in trus 

16 
The Bank insurance Fund 

Table 3 

BIF Cash Flows, 1987-91 

(Dollars in Billions) 

CASH INFLOW FROM: CASH OUTFLOW FOR: CASH 

Recoveries from Adm. and Payment of BALANCE 

Interest on Resolutions and Deer, (lncr.) Total Operating Disbursements Outstanding Total Net Flow DEC. 31 

Year Assessments U.S. Securities from Borrowings in Investments Inflows Expenses for Failed Banks Debts Outflows (Outflow) 

acquired in the course of failure and 

assistance transactions increased from 

6.8 percent of the total to 79.5 percent. 

This shift in portfolio mix from highly 

liquid Treasury issues to low-liquidity 

assets from failed institutions caused 

the BIF's overall liquidity to decline. 

Liquidity is important because it is 

primarily through the liquid assets in 

[he BIF and borrowing authority that 

assistance to failing banks and the pay 

ment of insured deposits can be carried 

out. 

Liabilities. The BIF's three major lia 

bility categories are estimated liabilities 

for unresolved cases, debt to the Treas 

ury's Federal Financing Bank (FFB), 

and liabilities incurred from failed or 

assisted banks. The first item repre 

sents the estimated cost to the BIF of 

probable losses from those banks that 

have not yet failed, but which the 

regulatory process has identified as 

either equity insolvent or "in-sub

stance" equity insolvent. At the end 

of 1991, the expected cost to the BIF 

of this liability item was estimated at 

$16.3 billion, out of $33.4 billion total 

liabilities. Liabilities to FFB arise when 

the FDIC arranges failure resolutions 

in a manner that minimizes cash out 

lays from the BIF. On such occasions 

the FDIG has used borrowed funds 

(mostly from FFB in recent years), in 

lieu of cash, in order to pay the ac 

quirer of the failed institution. At the 

end of 1991, $10.7 billion was owed to 

the FFB by the BIF. The third 

category, totalling $6.1 billion, repre 

sents liabilities incurred from failure 

resolutions. The bulk of this item 

[$5.6 billion) consists of funds held in 

escrow by the BIF on behalf of 

receiverships. Escrowed funds arise 

in resolution transactions when the 

failed bank's deposit liabilities are as 

sumed by another institution. If, in 

such instances, all of the failed bank's 

assets are assigned to the receiver 

ship, the FDIC must compensate 

with cash the acquiring institution for 

the amount of the assumed deposits. 

In most cases, however, the acquirer 

agrees to take a portion of the com 

pensation in the form of failed-bank 

assets in lieu of cash from the FDIC. 

The amount of cash freed by the ac 

quirer's acceptance of assets is placed 

then by the FDIC in an escrow ac 

count in the name of the receivership. 

The receiver, in turn, may draw upon 

this account for various specified pur 

poses, such as repurchasing assets un 

der put options, paying off preferred 

and secured claims, meeting receiver 

ship expenses, and declaring dividends 

to general creditors, including the BIF. 

Cask Flows 

Beginning in 1987, the FDIC's fi 

nancial statements have included in 

formation on cash flows in response to 

specific provisions issued by the Finan 

cial Accounting Standards Board. As 

might be expected, accounts and trans 

actions relating to failed-bank resolu 

tions have become dominant factors 

in the BIF's cash flow. As shown in 

Table 3, cash inflows from recoveries 

of failed or assisted banks plus bor 

rowings accounted for $18.5 billion 

(out of a total of $26.7 billion) in 1991, 

or about thrcc-and-a-half times the 

level of assessment revenue. Another 

$2.4 billion was derived from reduc 

ing investments. Cash from interest 

on securities, which in the past had 

been a major source of cash inflows for 

the BIF, amounted to only $0.6 billion 

in 1991. 

For 1991, cash disbursements for 

bank assistance and failures ($19.6 

billion), for payment of outstanding 

liabilities such as notes to acquiring 

banks ($5.8 billion), and for covering 

administrative and operating expen 

ses ($0.7 billion) accounted for $26.1 

billion in total cash outflow. This left 

the BIF with a cash balance on 

December 31, 1991, of $1.8 billion. 

Legislative Initiatives 

Assessment Policy 

Prior to FIRREA, insured banks 

paid assessments at a basic annual rate 

of 1/12 of one percent of assessable 

deposits which .are, roughly speaking, 

total deposits in domestic offices. 

Legislation in 1950 provided for a 

rebate to banks of a portion of their 

assessments in the form of an assess 

ment credit payable in the following 

year. As amended by legislation in 

1980, insured banks were rebated 60 

percent of the amount of the FDIC's 

assessment income in excess of its 

administrative and operating expen 

ses and provision for insurance losses. 

17 
FDIC Banking Review 

FIRREA made several important 

changes in the system of assessments, 

Beginning in 1990, the basic assess 

ment rate was increased to 0.12 per 

cent (from 0.0833), and the FDIC was 

given additional flexibility to adjust 

assessment rates and pursue reserve 

targets. 

FIRREA provided that the FDIC 

could increase the assessment rate 

to prevent a decrease in the BIF-to

insured deposits ratio. However, a 

bank's total assessment could not ex 

ceed 0.325 percent of its deposit base. 

After the BIF reached the reserve 

ratio of 1.25 percent, interest earned 

on additional reserves was to be paid 

out as dividends to insured banks. 

However, the FDIC could set the 

"designated reserve ratio" as high as 

1.50 percent, if necessary, to meeta risk 

of substantial future losses to the BIF. 

Borrowing Authority 

From its inception, the FDIC has 

had authority to borrow to meet li 

quidity needs. The Banking Act of 

1933 explicitly authorized the FDIC 

to issue "notes, debentures, bonds, or 

similar obligations . . . ." necessary to 

conduct insurance operations. The 

Banking Act of 1935 directed the 

Secretary of the Treasury to purchase 

up to $975 million of these obliga 

tions, although none were ever 

bought in this connection. In 1947, 

the specific authority to issue obliga 

tions to the Treasury was deleted, but 

specific authority to borrow up to $3 

billion directly from the Treasury was 

granted. 

FIRREA increased the FDIC's 

line of credit with the Department of 

the Treasury to $5 billion. Additional 

ly, FIRREA provided that the FDIC 

may borrow against illiquid assets, but 

only so long as it maintained a fund 

balance or net worth of at least ten 

percent of total assets. In borrowing 

for either the BIF or the SAIF, the 

FDIC ". . . may not issue any note or 

similar obligation, and may not incur 

any liability under a guarantee or 

similar obligation, with respect to 

either the Bank Insurance Fund or 

the Savings Association Insurance 

Fund if, after reduction for the es 

timated cost of the obligation or 

guarantee, the net worth of the af 

fected insurance fund would be less 

than 10 percent of assets." This net 

worth cushion was designed to absorb 

losses if acquired assets were sold for 

less than originally estimated. 

In October 1990, Congress enacted 

the Omnibus Budget Reconciliation 

Act of 1990, which changed a number 

of existing FIRREA provisions and 

added new statutory requirements. 

Most notably, the Act authorized the 

FDIC to set premiums for insured 

banks as necessary to maintain the 

actual reserve ratio of the BIF at the 

designated level, allowed the FDIC 

to make midyear adjustments in as 

sessment rates, and eliminated the 1.50 

percent designated reserve ratio ceil 

ing. At the same time, the Act per 

mitted the FDIC, on behalf of either 

the BIF or the SAIF, to borrow from 

the Federal Financing Bank. 

FDIC Improvement Act of 

199KFDICIA) 

By the end of 1990, the need to 

take decisive action to bolster BIF 

finances and enlarge the borrowing 

authority of the FDIC had become a 

matter of utmost urgency. Proposals 

for BIF recapitalization developed by 

the Department of the Treasury were 

introduced in Congress early in 1991. 

In November, Congress enacted the 

Federal Deposit Insurance Corpora 

tion Improvement Act of 1991, which 

was designed primarily to ensure that 

the FDIC, in resolving failures, did 

not run out of cash not to immedi 

ately restore equity in the BIF. The 

key provisions of FDICIA pertaining 

to the BIF are summarized below. 

Borrowingfrom the Department ofthe 

Treasury. The FDIC's $5.0 billion line 

of credit from the Department of the 

Treasury is increased to $30.0 billion. 

The FDIC may employ any funds 

drawn under this provision on behalf 

of either the BIF or the SAIF, and the 

borrowings will become a liability of 

the fund to which they are employed. 

Consent by the Department of the 

Treasury is necessary, as well as an 

agreement on how the borrowings will 

be repaid. The required repayment 

schedule must demonstrate that as 

sessment income will be sufficient to 

ensure repayment of principal and in 

terest of the debt. The FDIC can im 

pose special assessments on insured 

institutions to make up any shortfall. 

Such assessments must be allocated 

between BIF members and SAIF 

members according to which of the two 

funds has employed the proceeds of the 

loan from the U.S. Treasury. 

Limitation on Outstanding Obligations, 

FDICIA also redefined the limit on 

FDIC borrowings. FIRREA tied this 

limit to the net worth of the BIF. 

FDICIA provides, instead, that the 

FDIC's outstanding obligations may 

extend up to the total of its cash, 90 

percent of the fair market value of 

assets (other than cash) held by the 

FDIC, and the aggregate amount 

authorized to be borrowed from the 

U.S. Treasury. This change means that 

the FDIC can borrow outside the 

Treasury even if the BIF becomes 

insolvent. 

The Act defines "obligation" to in 

clude also any guarantee issued by the 

FDIC (other than deposit guarantees), 

as well as any contingent liability. The 

latter must be valued at its expected 

cost to the FDIC. 

With respect to borrowing from BIF 

members, such as notes issued to ac 

quiring institutions, FDICIA imposes 

conditions on both parties to the trans 

action. With respect to the FDIC, it is 

required that proceeds from the bor 

rowing be used solely for BIF-related 

functions; the interest rate paid to the 

lender cannot exceed the rate that the 

FDIC would have paid if the borrow 

ing were effectuated through the U.S. 

Treasury; and the amount required to 

pay interest and repay principal on the 

obligations cannot exceed assessment 

income. For BIF members purchasing 

obligations or making loans to the 

FDIC, it is required that the purchase 

18 
The Bank Insurance Fund 

money or the money loaned be derived 

from the members' capital or retained 

earnings. 

Assessment Rates. The Act stipulates, 

so long as the BIF's reserve ratio equals 

or exceeds the designated reserve ratio, 

that the FDIC Board set the semian 

nual assessment rates for members as 

necessary to maintain the reserve ratio 

of the BIF at the designated. 1.25 per 

cent level. This implies generally, so 

long as the investment yield on the 

BIF balance is at the same rate as the 

rate of growth in insured deposits, that 

the FDIC must implement a "pay-as

you-go" assessment policy, i.e., the as 

sessment revenue raised annually 

must be sufficient to fully cover total 

BIF expenses (insurance losses plus 

operating costs) for the year. 

Special Rules for Recapitalizing an 

Undercapitalized BIF. A different as 

sessment approach is envisioned, how 

ever, when the reserve ratio of the 

BIF is less than the designated ratio, 

as is currently the case. The FDIC is 

given two alternatives: (a) it can im 

pose semiannual assessment rates to 

generate sufficient revenue to raise 

the BIF ratio to the designated target 

within a year after such rates have been 

set or (b) it can promulgate through 

regulation a schedule of assessment 

rates that would allow up to 15 years 

before the designated 1.25 percent re 

serve goal is reached. When the second 

option is selected the FDIC Board is 

required to set assessment rates for 

members in accordance with a time 

schedule that specifies, at semiannual 

intervals, target reserve ratios for the 

BIF, culminating in the designated re 

serve ratio within 15 years. The 

FDIC may, by regulation, amend a 

previously promulgated schedule, but 

such an amendment must not extend 

the deadline for achieving the desig 

nated ratio. 

FDICIA Assessment Policy 

Appraised 

As discussed above, FDICIA pro 

vides two options to the FDIC after 

the target ratio is reached: (a) charge 

premiums sufficient to maintain the 

BIF at or above the target ratio; or (b) 

failing this, set forth a recapitalization 

schedule designed to restore the BIF 

to its target within 15 years. The first 

option will be referred to as "pay-as

you-go." Both of these options have 

drawbacks. 

The Nature of the Problem 

It is important to note that assess 

ment-setting encompasses two distinct 

types of problems and uncertainty. The 

first complexity relates to the require 

ment that the ratio of the BIF to in 

sured deposits must be at least 1.25 

percent. There is no widely accepted 

method of determining the optimum 

size of the BIF, either in terms of an 

absolute amount or in relation to some 

measure of exposure. The BIF has to 

be sufficient to cover losses and meet 

cash needs. Beyond that, however, its 

proper size depends upon the contin 

gencies the BIF is expected to handle 

and public perception regarding the 

FDIC's ability to meet its obligations 

under alternative economic scenarios. 

The second set of complexities 

arises from the unpredictable nature 

of bank failures and the erratic in 

cidence of insurance costs to the BIF. 

Neither failures nor insurance losses 

are spread evenly over time. Rather, 

in banking both tend to occur simul 

taneously. Under these conditions, a 

premium structure with the flexibility 

to deal with the varying loss situations 

over time becomes a necessity. If such 

a system requires insurance assess 

ments on banks in whatever amounts 

are necessary to keep the BIF ratio at 

the desired level, the higher assess 

ment premiums are likely to be 

charged when many banks are least 

able to afford them. The problem is, 

of course, compounded if the assess 

ment tevenue that must be raised in a 

given yeat must a Iso be allocated among 

banks according to each bank's risk 

status. High-risk banks then will be 

subjected to higher costs when they can 

least afford it, both from a businesscycle standpoint and in relation to com 

petitors designated as better risks. 

Premium-Setting Through 

Recapitalization Schedule 

When losses have caused the BIF 

to fall below its target ratio, and the 

FDIC does not charge an assessment 

sufficient to restore the BIF to its tatget within one year, it must promul

gate a recapitalization schedule 

allowing up to 15 years to reach the 

target. This approach has the advan 

tage of allowing the banking industry 

to absorb the burden of extraordinary 

losses over time. It does have certain 

drawbacks, however. 

First, the recapitalization schedule, 

by necessity, relies on assumptions 

about future insurance losses and de 

posit growth. Assumptions are open to 

debate, and hence the premium-set 

ting process can become highly politi 

cal. In turn, this makes the process 

uncertain and makes it difficult for 

insured institutions to plan ahead. 

In the next section, a moving-aver 

age approach to premium-setting is 

recommended when the BIF reaches 

its target. This would reduce the un 

certainties and ambiguities associated 

with the use of recapitalization sched 

ules. 

Premium-Setting Under 

the "Pay-As-You-Go" 

Approach 

As shown in Table 4, had the payas-you-go procedure been implemented 

in 1940, the assessment rate necessary 

to cover insurance losses plus operat 

ing expenses for that year would have 

amounted to slightly over one basis 

point. For the next 30 years this rate 

would have remained less than one 

basis point. Subsequently, the neces 

sary assessment charge would have 

increased gradually, but not until 1984 

would it have moved above the thenmaximum statutory assessment of 8.33 

basis points. During the late 1980s, 

It is ihis second option that is being imple 

mented by the FDiC currently. The proposed 

schedule indicates a 1.25 percent ralio for the 

BIF by Ihe year 2002. 
FD1C Banking Review 

Table 4 

BIF Cost Coverage Under Alternative Assessment Methods 

(Amounts in Millions of Dollars) 

however, the assessment race would and 69 points, respectively, for 1990 

have skyrocketed: 36 basis points for and 1991 (about three times the actual 

1988, 19 points the next year, and 55 assessment rate applied in either year). 

Clearly, the practical effect of such 

assessments on the industry is a cru 

cial issue. 55 basis-point assessment 

in 1990 and a 69-poim levy in 1991, for 

example, would have meant accrued 

costs for banks equal to 80 percent of 

their 1990 profits and 90 percent of 

their profits in 1991. Of course, not all 

of that cost would have fallen on pro 

fits, because part of it would have been 

deducted from taxes and probably an 

other portion would have been passed 

on to bank customers. 

Alternative Solutions 

As an alternative to the assessment 

system discussed above, consider a 

system where the annual assessment 

is based on a moving average of past 

losses and expenses. The general idea 

is that so long as insurance costs are 

high and rising, banks in a given year 

will be assessed at a lower rate than 

necessary to cover insurance costs. 

The reverse would be true when costs 

are falling. 

The Internal Revenue Code offers 

an example for a possible movingaverage formulation. Currently, small 

commercial banks (assets under $500 

million) may use for tax purposes the 

so-called "bank experience method" 

to compute additions to the reserve 

for loan losses. The allowed bad-debt 

reserve for a bank using the experi 

ence method is calculated on the basis 

of a six-year average, whereby the tax 

able year's losses on loans are aver 

aged with those of the previous five 

years. This six-year average is the max 

imum ending reserve balance permit 

ted for the year. 

similar approach may be adopted 

to allocate assessment premiums 

among members of the insurance 

fund. As indicated in Table 4, if an 

nual premiums were based on a sixyear moving average, the resulting 

assessment premiums would tend to 

be lower than the premiums neces 

sary to cover actual BIF costs when 

the latter are high and rising, as was 

the case during the 1980s. Thus, for 

1991, instead of 69 basis points under 

20 
The Bank Insurance Fund 

a pay-as-you-go system, banks would 

have paid only 33 points under the 

six-year formula. In other years, how 

ever, when actual coses were falling, 

as during 1979 and 1980, the assess 

ment rates under the six-year method 

would have exceeded the rates of the 

pay-as-you-go plan. 

The difference in realized revenue 

between an assessment policy aimed 

at capturing the actual costs in the 

BIF and one based on capturing costs 

as suggested by the six-year formula 

is shown in the far right column of the 

table. For a given year, a negative dif 

ference implies a deficit in the FDIC 

budget, while a positive difference im 

plies a surplus. The trend since the 

early 1980s has been for insurance los 

ses to consistently exceed assessments, 

resulting in budget deficits through 

out this period. Indeed, if the sur 

pluses and the deficits shown in the 

far right column of Table 4 were 

added together, the BIF would have 

accumulated a deficit of some $28 bil 

lion by 1991. If, however, the BIF 

losses change course in the years ahead, 

under the moving-average policy the 

collection of larger revenues than 

necessary to cover actual losses would 

tend to reduce to zero the $28 billion 

deficit, at which point the budget 

would become balanced. This oc 

curred, for example, in 1940, when 

budget costs and revenues according 

to the six-year average both equaled 

$7 million. For the next five years 

after 1940, the budget had surpluses. 

It became balanced in 1946, and fol 

lowing six years of deficit, the budget 

reached balance again in 19S3. Thus, 

under a moving-average policy, 

deficits and surpluses should tend to 

cancel each other out in the long run, 

and the budget should tend to 

gravitate toward balance. 

Applications 

A moving-average system of assess 

ments should result, over time, in a 

tendency for the BIF ratio to gravitate 

towards the ratio in effect when the 

system is implemented. Thus, if a 

moving-average approach were impleTable 5 

Revenues and Year-end Balances of the BIF 

Under Alternative Assessment Methods 

(In Millions of Dollars) 

Revenue/Assessment Method BIF Balance/Assessment Method 

mented when the BIF was negative, 

the BIF would tend overtime to remain 

negative. For this reason, given the 

Congressional mandate to achieve a 

1.25 percent BIF ratio, it would be 

inappropriate to implement a movingaverage assessment policy until that 

ratio is achieved. After the target is 

attained, however, the moving-average 

assessment approach offers advan 

tages over both the pay-as-you-go 

and the forecasted methods of setting 

premiums. 

Insights into the merits of such a 

policy may be gained by applying it to 

a past period when the BIF reserve 

ratio was actually at the 1.25 percent 

level. Using 1970 as a starting point, 

when the BIF reserve ratio stood ex 

actly at 1.25 percent, three different 

moving averages a six-, a four-, and 

a two-year average have been cal 

culated for subsequent years. The 

pay-as-you-go method has been ap 

plied also to the same data. It has been 

assumed in the calculations that when 

ever the BIF at year-end shows a posi 

tive net worth, it will realize an invest 

ment return of 8.5 percent on that net 

worth, and that when the year-end 

balance is negative, the BIF will incur 

an interest expense also equal to 8.5 

percent on funds borrowed to finance 

the negative balance. 

The assessment revenue implied 

by each of the four different assess 

ment methods, as well as the corre 

sponding year-end BIF balances, are 

shown in Table 5. If, from 1969 on 

ward, assessments were collected on 

the basis of a six-year moving average 

of actual BIF costs, the BIF would 

have accumulated a deficit of $10.7 

billion by 1991. Under the four-year 

average, the BIF would have almost 

broken even, while the two-year and 

the pay-as-you-go policies would have 

generated BIF surpluses of $13.9 bil 

lion and $24.4 billion, respectively, by 

the end of the period. In general, the 

more years included in a moving-aver 

age formulation, the greater will be 

3In all years before 1970 the ratio exceeded 

1.25 percent. 

A 8.5 percent is approximately the same rate 

as the average yield on the BIF's investment 

portfolio during the period 1970-91. 

21 
FDIC Banking Review 

the potential deficit in the BIF during responding reserve ratio for each 

cyclical downturns, when failure costs method. Only the pay-as-you-go 

are on the rise. But, by the same token, method would have maintained the BIF

ratioat 1.25 percent through 1991. This the longer average would tend to pro 

result, however, would have required duce higher BIF surpluses when con 

relatively high assessment rates. Under ditions improve and failure losses begin the two-year average, the BIF ratio to decline. would have remained positive, and the 

Figure 1 shows the assessment rates assessment rate would have been con 

necessary under each of the four siderably less than under the pay-as

methods named previously and the cor you-go method. he other two methods 

Figure 1 

Premium Rates and BIF Reserve Ratios 

Under Alternative Assessment Methods 

Assessment Rate (Basis Points) 

70 

Pay-As-You-Go 

2-Year Movincj Average 

4-Year Moving Average 

50 

6-Year Mewing Average 

40 

30 

20 

10 

1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 

Reserve Ratio (% of Insured Deposits) 

1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 

would have resulted in negative BIF 

ratios by the end of the period, as well 

as lower assessment rates. As noted 

previously, so long as the BIF and 

insured deposits both grow at the 

same rate, the reserve ratio will tend 

to stay at the 1.25 percent level. This 

did not happen during 1970-91 be 

cause Congress raised the insurance 

coverage twice in 1974 to $40,000 

from $20,000, and again in 1980 to 

$100,000 — which caused insured 

deposits to grow faster than the BIF. 

In general, the longer the movingaverage interval under consideration, the 

less will be the year-to-year variability 

in assessment rates and the larger will 

be the deviation of the BIF reserve ratio 

above or below the 1.25 percent line. 

Allocating assessment costs on an 

"average" rather than on a pay-as-you

go basis would in the long run be 

expected to generate enough revenue 

to fully pay for the insurance costs 

accruing to the BIF. The BIF itself 

will not get balanced every single year 

at the designated ratio, but over time 

it should average out to a 1.25 percent 

ratio. The ultimate objective of this 

approach would be to balance the BIF 

budget on a long-term basis, thereby 

easing the economic burden to BIF 

members. 

As emphasized above, periods of 

heavy losses to the BIF tend to coin 

cide with periods of poor earnings for 

the industry as a whole. A movingaverage assessment approach will, thus, 

tend to have a countercyclical effect 

on bank income. From this perspec 

tive, the current risk-based assess 

ment policy will be rendered less bur 

densome to the industry, thus making 

it easier for the FDIC to sustain such 

a policy. Simply put, as compared to 

the pay-as-you-go method, an assess 

ment policy based on a moving 

average is likely to render the assess 

ment costs to BIF members more pre 

dictable and stable from year to year, 

and less of a burden during hard 

economic times. In the long run, of 

course, costs should average out to the 

same figure undereitherapproach. 

Finally, the use of a moving-aver 

age approach after the BIF target 

is attained would avoid the use of 

22 
The Bank Insurance Fund 

assumptions and forecasts implicit in 

a 15-year recapitalization schedule. 

Because a moving-average approach 

would rely on a predetermined formula, 

premium-setting would be insulated 

from the political process and would 

become more predictable. 

Concluding Comments 

Assessment revenue raised by the 

FDIC since the early 1980s fell far 

short of the amounts required to cover 

the costs of bank failures during this 

period. In order to pay for insurance 

losses and provide assistance to 

troubled institutions, the FDIC was 

forced to liquidate securities and to 

borrow. As a result, both BIF liquidity 

and cash balances have been reduced 

substantially. Most of the portfolio as 

sets in the BIF (once almost totally 

consisting of Government securities) 

are currently in the form of claims 

against receiverships or loans to as 

sisted banks assets that generally 

are difficult to sell or liquidate quick 

ly. Unfortunately, even though in the 

last three years the assessment rate 

has almost tripled., the revenues real 

ized have not fully covered the in 

surance costs to che BIF. 

There are, to be sure, compelling 

arguments as to the level of assess 

ments that banks can absorb, or at 

what point increased premiums be 

come counterproductive from the 

standpoint of industry viability. 

These limits, however, have not been 

tested Congress did not require the 

FDIC to adhere to a strict "pay

as-you-go" policy in response to the 

large insurance losses in recent years. 

Instead, concurrent with the author 

ity to raise premiums. Congress in 

creased the FDIC's ability to borrow 

from the Department of the Treasury 

and other sources. Thus, two-thirds of 

the insurance losses in 1991 were fi 

nanced through borrowings from the 

Federal Financing Bank. 

This paper has proposed that when 

the BIF reaches its target ratio, assess 

ments should be based on a moving 

average of past losses. Such an approach 

would avoid both the potential burden 

on the banking industry implicit in a 

pay-as-you-go approach, and the reli 

ance on assumptions and forecasts 

implicit in a 15-year recapitalization 

schedule. Annual assessments would 

be determined, instead, on the basis 

of a fixed formula, known and under 

stood ahead of time by al I concerned. 

REFERENCES 

Congressional Budget Office. Budgetary Treatment of Deposit Insurance; A Framework for Reform. 

Washington, D.C: Congressional Budget Office, May 1991. 

Federal Deposit Insurance Corporation Improvement Act of 1991. Pub. L. No. 102—242. 

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

Office of Management and Budget. Budgetingfor Federal Deposit Insurance. Washington, D.C: Office 

of Management and Budget, June 1991. 

Zl 
FDIC Banking Review 

0 o . o 

asitnomi: 

SLUiiet e 

arket vs. Out-of-Market Cost Effects 

by Neil B. Murphy5 

In the past several years, the bank 

ing industry has undergone 

substantial consolidation. This 

occurs as hanks eliminated by mergers, 

acquisitions, and failures exceed the 

number of new banks chartered. Many 

observers believe that this consolida 

tion is beneficial. Banks are thought tc 

become more efficient, and a larger geo 

graphical lending area allows them to 

benefit from risk diversification.That 

is, banks with wider geographical 

operations are less vulnerable to spe 

cific industry or local economic 

downturns. This diversification has 

occurred as the restrictions on inter 

state banking have been removed 

during the past decade. 

There are, however, some skeptics 

an the alleged efficiency benefits from 

consolidation. Many studies have 

found that economies of scale in 

banking are confined to very small 

banks, and, indeed, some studies even 

find diseconomies of scale at high levels 

of output. These skeptics suggest that 

bigness does not necessarily indicate 

efficiency. 

Another concern arising from the 

consolidation of the banking industry 

is the effect on competition. Does 

[he removal of competitors indicate 

that the public may not receive the 

benefits of a vigorous, competitive 

process? 

A related question arises for the 

Fedetal Deposit Insurance Corpora 

tion (FDIC) as it resolves failed-bank 

situations. In most cases, the insured 

deposits of a failed bank have greater 

value to another bank than to the 

FDIC. That is, it is usually cheaper 

for the FDIC to "sell" the insured 

deposits of a failed bank to another 

bank than it is to pay off the depos 

itors. In most cases, the FDIC seeks 

to find a bidder (or bidders) for the 

insured deposits (and some of the 

failed bank's assets) that will result in 

the lowest overall cost in resolving the 

failure. If some of the bidders are lo 

cated in the same market area while 

others are located elsewhere, then 

there is a possible dilemma. Accep 

tance of the bid from the in-market 

bank results in fewer remaining com 

petitors than would be the case if a 

bid from an out-of-market bank were 

accepted. 

Does a high bid from an in-market 

bank reflect ability to manage the in 

sured deposit base more efficiently or 

does it reflect a desire to reduce the 

number of competitors in the market 

area? In this article, the potential ef 

ficiency impact is evaluated. Using 

standard econometric analysis, it is 

found that in-market bidders who sys 

tematically close redundant and over 

lapping branches can indeed manage 

the insured deposit activity more effi 

ciently. This result occurs because while 

there may not be economies of scale as 

banks expand, there usually are econ 

omies of scale as the typical branch 

expands. This is a subtle but impor 

tant distinction that pervades the 

literature on bank costs for the past 

four decades and is verified by the 

sconometric analysis in this article. In 

the next section, possible reasons for 

the existence of costly branch systems 

are discussed. Following that discus 

sion, the results of many previous 

studies of bank costs and branching 

Neil B. Murphy is Professor of Finance, and 

Chairman, Department of Finance and Insurance, Vir 

ginia Common wealth University, Richmond, Virginia. 

Thisarticle was prepared while rhc author participated 

in the FDIC's Visiting Scholar Program. 

24 
Acquisitions of Failed-Bank Deposits 

are summarized. The section follow 

ing the summary contains the results 

of an economeinc analysis along with 

a simulation of several mergers to 

show the possible cost savings from 

dosing branches. The last section is 

the summary and conclusions. 

Reasons for Existence of Costly 

Branch Systems 

Before proceeding, a question 

arises. Why would banks institute a 

more costly system of delivering ser 

vices by establishing a large number 

of small branches if it is indeed true 

[hat there are economies of scale in 

the size of branches? There are two 

logical reasons. First, the measurement 

of economies of scale is concerned 

with operating costs at various branch 

sizes. A larger number of small 

branches may increase the banks' 

operating costs, but this may be offset 

by consumers' increased willingness 

to pay for conveniences such as re 

duced travel time and reduced time 

spent waiting for service. Consumers 

may pay for such services either by 

accepting lower interest retumson their 

deposits or paying higher service fees 

or interest charges on loans than 

otherwise would be the case. Second, 

an historical reason for the establish 

ment of a large number of branches 

was the existence of controls on inter 

est payments that banks could make 

to consumers on their deposiis. This 

set of controls, commonly referred to 

as Regulation Q, indirectly encour 

aged banks to compete for deposit 

funds by non-price means. One way 

of attracting funds in such an environ 

ment is the provision of convenience, 

as a substitute for interest payments, 

through the establishment of many 

attractively located branches. Prior to 

the passage of legislation removing 

the deposit interest ceilings, there were 

times during the 1970s when banks 

were constrained to pay five percent 

to depositors while the prime rate 

exceeded 20 percent. While such 

spreads were not prevalent during the 

entire period of 1966 to the early 1980s, 

it was generally the case that banks 

had incentives to offer their depos 

itors more than the regulated ceiling. 

This included giveaways, such as 

blankets and toasters; reduced service 

charges and fees; provision of loans to 

deposit customers at preferential rates; 

and establishment of conveniently lo 

cated branches. 

There have been a number of de 

velopments that have changed in the 

past decade. First, banks now offer 

services that are not as tied to specific 

locations. More people are changing 

the way they conduct their banking 

business. The spread of automated 

teller machines (ATMs) and direct 

deposit means that many customers 

do not go to branches for the conduct 

of usual banking business. Moreover, 

surveys of customer usage consistent 

ly show that ATM users are "upscale" 

consumers possessing, among other 

things, higher incomes than non-users. 

These desirable customers have little 

need to place much value on the ex 

istence of an extensive branch net 

work. Banks' competiiors have been 

very successful in developing substi 

tutes for deposits without establishing 

costly branch networks. Money-market 

mutual funds have grown dramatically, 

offering a service mat is substantially 

the same as a bank deposit, without 

the need of a branch network. In this 

case, the telephone and mail systems 

are a low-cost substitute delivery sys 

tem. Insurance companies and credit 

unions have effectively marketed 

financial services in and through the 

workplace without having to construct 

a brick-and-mortar delivery system. 

Thus, consumer attachment to the 

branch system has eroded over time 

through a combination of technology 

and innovation. 

Another recent development is elim 

ination of ceilings on interest rates. 

For many reasons, it became clear that 

these restrictions hurt both consumers 

and banks. Consumers were deprived 

of the benefits of price competition 

for their deposit funds, and banks saw 

numerous competitors, especially 

money-market mutual funds, take busi 

ness away from them because they 

were constrained by regulation from 

paying a competitive interest rate to 

their depositors. In 1980, legislation 

was passed to remove all these ceil 

ings, and, with the aid of companion 

legislation in 1982, all such regula 

tions are now relegated to history. 

This leaves the banking industry in 

a difficult position. On the one hand, 

the banks must compete on a price 

basis with their competitors. On the 

other hand, consumers have grown ac 

customed to having branches in con 

venient locations. Banks have had to 

adapt to an environment in which they 

faced increased deposit costs through 

most of the 1980s with no easy way ta 

reduce their operating costs through 

the closing of branches. In addition, 

banks have not charged the full cost 

of their transactions and other services 

to their customers, a practice under 

standable in the Regulation Q envi 

ronment. Customers have grown 

accustomed to this as well, making it 

difficult to raise charges and fees. 

Nonetheless, banks have slowly tried to 

rationalize their delivery systems and 

pricing of services in the new environ 

ment. One way of rationalizing the 

delivery system is to carefully consider 

closing redundant and overlapping 

branches in the wake of a merger. 

Results of Previous Studies 

There have been studies of costs in 

banking for almost four decades. These 

studies reveal a pattern of results over 

time that supports the notion that many 

bank branches are too small to be ef 

ficient. Early studies were conducted 

by Alhadeff (1954) and Horvitz (1963). 

In these studies, the authors compared 

costs within asset size categories for 

banks with and without branches. 

There was a consistent pattern of 

higher costs for branch banks. These 

studies have been criticized on the 

grounds of lumping all branch banks 

together, not adjusting for product mix, 

and not having an explicitly-derived 

cost model. Nonetheless, these 

authors first suggested thai branching 

was more expensive and set the stage 

for subsequent studies. 

25 
FDIC Banking Review 

A number of studies followed, 

utilizing a different data source and a 

different methodological approach. 

Benston (1965) and Bell and Murphy 

(1968) utilized the Federal Reserve's 

Functional Cost Analysis (FCA) data 

for their studies. The question of 

product mix was addressed by break 

ing the bank into a set of products 

(functions) and examining the cost

output-branching question using an 

explicit: cost model known as the 

Cobb-Douglas production function. 

These authors found that branching 

was more costly for several functions, 

especially the deposit-gathering func 

tions. That is, the same output 

produced at a large number of small 

offices is more expensive than when 

produced at a single larger facility. In 

a separate article, Bell and Murphy 

(1969) used their econometric model 

to simulate the cost structure of banks 

in a number of Northeastern metro 

politan areas, and they found that 

higher branch costs for large banks 

largely offset the economies of scale 

for banks found at that time. 

Longbrake and Haslem (1975) ex 

panded the sample, refined the 

specification of the branching vari 

able, and considered the cost effects 

of other organizational variables. 

Using the same basic approach as 

Benston and Bell-Murphy, they con 

firmed the earlier findings. 

In a study of banks in New Jersey, 

New York, and Connecticut, Nelson 

(1985) used a single equation, linear 

model with several outputs and 

branching as variables. He found 

declining average costs at the branch 

level, implying that efficiencies could 

be achieved by increasing the average 

size of branch. 

Most of the studies in this area 

have used the individual bank as 

the basis of analysis. That is, costs 

for the bank are compared to other 

banks' costs using appropriate statis 

tical techniques. However, some 

authors have examined costs within a 

single bank using the individual 

branch as the basis of the analysis. 

Murphy and Orgler (1982) examined 

the cost structure of 127 branches of a 

large Israeli bank and found substan 

tial scale economies. In a study of a 

Greek bank, Pavlopoulos and 

Kouzelis (1989) found that there are 

U-shaped cost curves, implying an 

optimal size branch. That is, average 

costs at first decline as output in 

creases and, then, after a point begin 

to rise. The point of the lowest cost is 

the optimal size branch. In a related 

study. Fields and Murphy (1989) ex 

amined the cost structure of life 

insurance agencies. These are similar 

to bank branches in that they deliver 

financial services "manufactured" 

elsewhere. They found substantial 

scale economies to the life insurance 

agency, usually a single office 

delivery point for insurance services 

provided by insurance companies. 

The results of these studies are 

generally supportive of the existence 

of scale economies to the branch of 

fice although the evidence is indirect; 

one from another financial-service in 

dustry and two from Mediterranean 

countries. 

In the 1980s, new techniques were 

applied to the data to test for the ex 

istence of scale economies in banking 

and the effect of branching. The new 

techniques, referred to as flexible, 

multiproduct cost functions, are 

usually estimated using a cost equa 

tion known as the transcendental 

logarithmic function, or the translog. 

In applying this model, Berger, Han

weck, and Humphrey (1987) estimate 

scale economies for two situations. 

First, a measure is computed if it is 

assumed that output expands and 

branches do not. Second, a measure is 

computed assuming that output ex 

pansion is accompanied by branch ex 

pansion at the rate found in their 

sample. They find that measures of 

scale economies always show that 

expansion of output without expan 

sion of branches leads to lower 

costs than otherwise would be the 

case. That is, increasing the average 

size of branch almost always lowers 

cost, holding constant the level of out 

put and other pertinent variables. It 

also should be noted that they find 

some branches that are too large, 

showing diseconomies of scale, 

implying a U-shaped cost curve 

and an optimal size of branch. The 

existence of branches that are larger 

than the optimal size is confined 

to large banks in unit banking states. 

However, for our purpose, the 

analysis is designed for branch 

banking states in which it is unlikely 

that many branches are larger than the 

optimal size. It also should be noted 

that the trend for state legislation is to 

expand the ability of banks to branch, 

reducing the number of unit banking 

states. 

In summary, the results of 

many studies show that banks have 

excess productive capacity at many of 

their branches. The forces of 

deregulation of interest ceilings and 

technological change, noted above, 

push banks in the direction of at 

tempting to rationalize their delivery 

systems. Thus, a merger that resulted 

in closing of redundant and over 

lapping branches presents an oppor 

tunity to pursue cost savings in most 

instances. From the perspective of 

the bidder on a failed bank's insured 

deposits, this implies that an inmarket bidder could reduce costs 

by closing branches without adverse 

ly affecting its market position. 

Hence, such a bidder would find 

the failed bank's deposits more valu 

able and would be motivated to 

make a higher bid than an out-of

market bidder. This higher bid occurs 

because of possible efficiencies in 

operating the deposit functions rather 

than any increased concentration 

in the market. This result is robust 

in that the findings of these 

studies are similar over time and 

with different approaches to esti 

mating the cost functions. The results 

of the studies are summarized in 

Table 1. 

This data source is ucilized in this article 

and is described in greater detail below. 

26 
Acquisitions of Failcd-Rank Deposits 

Table 1 

Summary of Previous Studies on Costs and Branching 

Author! s) Method/Unit of Observation Findings 

Alhadeff<1954) 

Horvitz<1963) 

Benston(1965) 

Bell and Murphy (1968) 

Bell and Murphy(1969) 

Longbtake and Haslem (1975) 

Nelson (1985) 

Murphy and Orgler(1982) 

Pavlopoulos and Kouzelis (1989) 

Fields and Murphy (1989) 

Bergerand Humphrey (1987) 

Tabular/Banks 

Tabular/Banks 

Cobb-Douglas/Banks 

Simulation of Cobb-Douglas/Banks 

Cobb-Douglas/Banks 

Linear Model/Banks 

Cobb-Douglas/B ranches 

Translog/B ranches 

Translog/Individual Insurance Agent Offices 

Translog/Bank 

Complete citations areshciwn in ihc list of T 

Estimation nfthe Impact of 

Branching on the Operating 

Costs of the Deposit Functions 

In order co update the studies dis 

cussed above and to estimate a model 

that is specifically relevant for the ques 

tion posed in this article, a separate 

econometric analysis was performed. 

A bank that is considering making a 

bid to acquire the deposits of a failed 

bank must consider the cost of operat 

ing and servicing the accounts that are 

acquired. For purposes of this article, 

such an insured-deposit base will be 

referred to as an "insured-deposit 

franchise.'1 

Thus, such a cost model should 

represent the costs of operating an 

insured-deposit franchise with special 

emphasis on the impact of branching. 

The data for the study are computed 

from the Federal Reserve's Function 

al Cost Analysis Program, which is a 

voluntary program conducted by the 

twelve Federal Reserve Banks for com 

mercial banks and savings banks in 

their districts. Each bank agrees to 

participate and ptovide data accord 

ing to an agreed-upon format. The 

banks themselves participate in the 

development of the format so it re 

flects their interests rather than those 

of a regulator. Each bank allocates 

costs to a number of different product 

lines (functions) according to account 

ing rules upon which all agree. In ad 

dition, data ate gathered reflecting 

the number of accounts in each func 

tion, the dollar volume in each ac 

tivity, the number of transactions, the 

numbet of employees and officers in 

volved in the provision of services, and 

the number of branches operated by 

the bank. Each participating bank sub 

mits the data to its Federal Reserve 

Bank. The Reserve Bank then proces 

ses the data and provides the bank 

with reports on their comparative costs. 

This source of data has some de 

sirable characteristics for the purposes 

of this study. First, it is the only data 

source that would permit the analysis 

of the insured-deposit franchise 

separately. Second, it is the only data 

source that has information on physi 

cal items such as number of accounts 

and number of transactions. It is 

reasonable to assume, for example, 

that it is more costly to service 10,000 

deposit accounts of $500 each rather 

than 5,000 accounts of $1,000 each, 

even though the total dollar volume is 

$5,000,000 in both cases. 

However, there are some drawbacks 

to using this data source. The major 

drawback is the size distribution of 

the sample. Both very small and very 

large banks are underrepresented in 

the sample, which limits the useful 

ness of the results. It is difficult to 

exttapolate the results of the analysis 

beyond the size distribution of banks 

found in the sample. Recognizing the 

Branching more expensive 

Branching more expensive 

Branching more expensive 

Branching more expensive 

Branching offsets scale economies 

Branching more expensive 

Branching more expensive 

Large branches more efficient 

Some branches are too small, others too large 

Large offices more efficient 

Some branches are too small, others too large 

limitations of the data, the benefits 

are sufficient to make the analysis 

worthwhile. 

In this cost model, banks' costs of 

providing demand deposits and time 

deposits are estimated as a function of 

the number and size of accounts, the 

number of branch offices, and the 

wage rates of bank personnel (Table 

2). The purpose is to estimate scale 

economies in providing deposit ser 

vices at the franchise and the branch 

level. Each of the two equations es 

timated has a dependent variable and 

a group of independent variables. 

Movement of the independent vari 

ables explains the movements of each 

of the two dependent variables. 

There is an estimated coefficient as 

sociated with each independent vari 

able that measures the response of the 

dependent variable to changes in that 

independent variable, holding con 

stant the influence of all other inde 

pendent variables. The scale 

economy measures indicate what 

happens to expenses if output vari 

ables increase by a certain percentage. 

That is, if there is a ten percent in 

crease in output, it is said thai 

economies of scale exist if cost in 

creases by less than ten percent. An 

increase of exactly ten percent in cost 

is referred to as constant returns to 

scale, while an increase of more than 

ten percent is known as diseconomies 

of scale. 

27 
FDIC Banking Review 

Table 2 

Description of Variables 

Variable Description 

EXPDA Tocal direct expenses allocated to the demand deposit function, 

including regular checking, special checking, and interest-bearing 

checking 

EXPTA Total direct expenses allocated to the time deposit function, includ 

ing regular savings accounts, club accounts, money-market deposit 

accounts, retirement accounts, and certificates of deposit under 

$100,000 

NDA Total number of demand deposit accounts 

NTA Total number of time deposit accounts 

ANDA Average size of demand deposit account 

ANTA Average size of time deposit account 

WEDA Average annual wage rate of all employees in the demand deposit 

function 

WODA Average annual wage rate of all officers in the demand deposit 

function 

WETA Average annual wage rate of all employees in the time deposit 

function 

WOTA Average annual wage rate of all officers in the time deposit function 

B Total number of offices the bank operates 

Source: All banks participating in the Ftdecul Reserve's Functional Cost Analysis Program in 1987,1988. 1989. 

Advances in the theory of cost and First, all variables are transformed 

production indicate that some transfor into logarithms. Second, squared and 

mation of the variables is necessary cross-product terms are added to the 

before the cost equations are estimated. independent variables. Third, some 

restrictions are imposed on some of 

the coefficients of the resulting equa 

tions. These are all necessary to es 

timate a multiproduct cost function, 

and this particular model is known as 

the transcendental logarithmic cost 

function, or the translogcosi function. 

Those cost functions are shown in 

Table 3. 

The equations were estimated si 

multaneously using a technique known 

as "seemingly unrelated regression," 

or SUR, the standard procedure for 

such models. The tesults may then be 

interpreted to determine whether scale 

economies are present as well as the 

effect of branching on the results. For 

that purpose, two general measures 

are computed. First, the measured scale 

economies are calculated assuming that 

expansion of output occurs with no 

increase in the number of branches. 

This' is referred to as returns to the 

"plant," each office being viewed as a 

separate plant producing deposit ser 

vices. Second, the scale economies 

measure is calculated assuming that 

output expansion is accompanied by 

branch expansion at the rate found in 

the sample. That is, higher output is 

generally associated with more 

branches, and the nature of that as 

sociation is obtained from the sample 

banks. The first measure is called re 

turns to scale, plant effect; the second 

is called returns to scale, franchise ef 

fect. In the literature on production 

and cost, the second measure is usual 

ly known as the "firm effect," but 

here the emphasis is on the deposit 

franchise. Hence, it is called the 

"franchise effect." 

The results are shown in Table 4. 

The scale measures, or elasticities, are 

calculated from the estimated equations. 

Because there are squared and cross

product terms in the equation, a single 

measure of scale economies does not 

emerge from the model. Rather, scale 

economy measures are computed at dif 

ferent levels of output. In Table 4, the 

scale economy calculations are made at 

the mid-point of each quartile of sam 

ple output and at the median value 

of sample output. For example, at the 

median level of output in 1987, the scale 

economy measure, franchise, is .8901. 

This indicates that a ten percent in 

crease in output, along with the branch 

expansion observed in such a situation, 
Acquisitions of Failed-Bank Deposits 

is accompanied by an 8.9 percent in 

crease in costs. The scale economy 

measure, plant, is .8357. This indicates 

chat an expansion often percent in out 

put with no change in branches is ac 

companied by an 8.4 percent increase 

in cost. The interpretation is as follows: 

1. The franchise effect measures the 

percentage increase in costs in the 

situation where the number of bran 

ches expands in relation to output 

at the same rate as is found in the 

sample. Since there is a positive 

relationship between output and 

branching in the sample, expand 

ing output is accompanied by a 

larger number of branches. Hence, 

the average size of branch does not 

increase as much as is the case when 

the plant effect is measured. The 

results show that average cost is 

reduced in this situation, i.e., there 

are some economies of scale. 

2. The plant effect measures the per 

centage increase in costs in the 

situation where total bank output 

expands, but the number of bran 

ches stays the same. Thus, by defi 

nition, branch size is increasing 

more than is true for case "1." The 

reduction in average costs in this 

situation is greater than in case "1." 

One concludes that there are 

greater potential scale economies 

for banks that can expand output 

by increasing branch size. 

Inspection of Table 4 shows that in 

all cases the returns to scale, plant, 

elasticities are lower than those of the 

returns to scale, franchise. This means 

chat expanding output without in 

creasing the number of branches leads 

to lower costs than expanded output 

accompanied by more branches. This 

is consistent with the findings of pre 

vious studies discussed above. 

In the normal course of events, 

banks may find it difficult to close 

branches to achieve efficiencies. That 

is, concerns about adverse customer 

reaction and unfavorable community 

response would make most hanks hesi 

tant about closing branches in most 

situations. The move to more effi 

cient size is more likely to be accom 

plished through growth of existing 

branches. However, the acquisition of 

a failed-bank franchise represents a 

unique opportunity to acquire a source 

of funds and close branches at the 

same time. In many cases, the cus 

tomers of the failed-bank branches 

would have another branch of the ac 

quiring bank nearby, and closing the 

branches of a failed bank is not likely 

to have the same customer and com 

munity reactions, especially if nearby 

substitutes are available. 

Merger Examples; 

Two Simulations 

Because the results derived from 

the cost function estimated here de 

pend upon the level of output, there 

is no general finding that can be 

reported regarding the magnitude of 

savings from acquiring a failed-bank 

deposit franchise and closing 

branches. Therefore, two examples are 

given with simulated data using the 

estimated cost model. 

For the first simulation, a bank is 

considering bidding for the deposits 

of a failed bank within its market area. 

The values for this simulation are taken 

as representative values based upon 

author judgment. Total deposits in 

the failed bank are $62,323,767, with 

20.85 percent in demand deposits and 

79.15 percent in time and savings depo 

sits. There are 3,852 demand deposit 

accounts and 5,759 time and savings 

deposit accounts delivered at three 

branch offices. The potential bidder 

is a larger bank with total deposits of 

$160,335,072, with 23.03 percent in 

demand deposits and 76.97 percent in 

time deposits. There are 8,728 demand 

deposit accounts and 10,492 time and 

savings deposit accounts at five branch 

offices. The procedure for determining 

the cost effects is as follows: Holding 

constant the impact of wage rates, con 

sider the incremental annual costs of 

operation, indicated by the model, of 

acquiring the deposits if none, one, or 

all three branches are closed after the 

acquisition. 

The results of the cost simulation 

are shown in Table 5. The acquiring 

bank's costs are calculated before and 

after the acquisition. The incremental 

cost of the acquisition is then shown 

under different assumptions about 

the closing of branches. In each case, 

the closing of branches is accom 

panied by a reduction in costs. Maxi 

mum cost savings occur when all three 

branches are closed, averaging 18.3 

percent for each of the three years. 

Even closing one branch is associated 

with cost reductions of six percent 

using the 1987 model, 4.5 percent for 

the 1988 model, and five percent for 

the 1989 model. 

For the second example, consider 

two banks of equal size, one of which 

has failed. Each bank has total 

deposits of$96,175,535, with demand 

deposits comprising 24.3 percent and 

time deposits 75.6 percent, respective 

ly, of the total. Each bank has 6,552 

demand deposit accounts, 8,406 time 

deposit accounts, and operates three 

branch offices. The results of the 

simulated acquisition are shown in 

Table 6. In each case, the closing of 

branches after the acquisition is 

accompanied by a reduction in the 

annual operating costs. Savings from 

closing one branch are an average of 

4.4 percent for each of the three years 

Table 4 

Ray Scale Economies, Franchise and Plant, 1987-1989 

Year 1987(F) 1987(P) 1988(F) 1988(P) 1989(F) 1989(P) 

Mid-point 1st Quartile 

Mid-point 2nd Quartile 

Median 

Mid-point 3rd Quartile 

Mid-point 4th Quartile 

.8490 

.8865 

.8901 

.8884 

.8607 
FD1C Banking Review 

while savings from closing all three 

acquired branches are an average of 

15.3 percent for each of the three 

years. 

In both cases, it should be em 

phasized that these savings occur an 

nually. That is, the present value of 

the stream of the savings would be 

greater than what is shown here for a 

single year. Of course, the present 

value of all future earnings is the ap 

propriate basis for formulating a bid 

for a failed-bank franchise. The 

results of the analysis here indicate 

that such savings would have an im 

portant impact on the price that an 

in-market bidder would be willing to 

paytheFDIC. 

Savings from branch closings in 

failed-bank situations most likely are 

greater than estimated here. A 

byproduct of branch closings in fail 

ing-bank situations may be the 

elimination of poorly-managed, highcost branches. This type of cost 

savings relates to the operational ef 

ficiency, not the size, of branches 

before versus after the failure-resolu 

tion transaction. Humphrey (1987, 

1991) has shown that if all banks were 

as efficient as the most productive ten 

percentof the industry, savings would 

exceed what is available if all banks 

merely reached the optimal size. 

Thus, if mergers, whether voluntary 

or not, result in the remaining bank 

being among the most efficient, cost 

savings can be substantial. Banks 

usually fail because of poor credit 

judgments, but it is reasonable to sup 

pose that such banks are also highcost producers as well. Limited 

research by Kolari and Zardkoohi 

(1987) and Siems (1992) support this 

view. Therefore, in addition to the 

cost savings from increasing the 

average size of branch, it is likely that 

the surviving bank would also manage 

the franchise more efficiently. 

Summary and Conclusions 

In recent years, the number of 

bank failures has increased substanTable 5 

Cost Effects of Franchise Acquisition, Scenario One 

1987 1988 1989 

Table 6 

Cost Effects of Franchise Acquisition, Scenario Two 

daily. One consequence of this pro 

cess is that a large number of insureddeposit franchises are available for sale 

by the FDIC which attempts to capture 

the franchise value of these deposits in 

selecting bids from interested banks. 

Banks that acquire an insured-deposit 

franchise establish bids based upon 

expected net future earnings from the 

acquisition. The cost of operating the 

franchise is an important determinant 

of those benefits. Bidders that are in 

the same market area may have an 

incentive to post higher bids if they are 

able to close small branches in the 

1987 1988 1989 

process. This incentive exists because 

of cost savings rather than an increase 

in market power. This is suggested 

by the results of previous studies on 

costs and branching. In this article. 

the cost of operating deposit func 

tions, a proxy for the insureddeposit franchise, is examined. It is 

found that the branching effects of 

previous studies are confirmed here. 

Moreover, simulations of specific 

transactions show that the cost 

savings are substantial. As a ptactical 

matter such savings are largely con 

fined to in-market bidders. 
Acquisitions of Failed-Bank Deposits 

REFERENCES 

Alhadeff, David A. Monopoly and Competition in Banking. Berkeley: University of California Press, 1954. 

Bell, Frederick W., and Neil B. Murphy. Costs in Commercial Banking: A. Quantitative Analysis of Bank Behavior and 

Its Relation to Bank Regulation. Research Report No. 41, Federal Reserve Bank of Boston, 1968, 

. "Economies of Scale and the Division of Labor in Commercial Banking." Southern Economic Journal 

35(1968):131-39. 

. "The Impact of Regulation on the Inter- and Intra-Area Variation in Bank Costs." Journal of Regional 

Science 9 (1969):22S-3S. 

Benston, George J. "Branch Banking and Economies of Scale." Journal of Finance 20 (1965):312-31. 

Benston, George J., Gerald A. Hanweck, and David B. Humphrey. "Scale Economies in Banking: A Restructuring 

and Reassessment." Journal ofMoney, Credit and Banking 14 (1982);435-56. 

Berger, Allen N., Gerald A. Hanweck, and David B. Humphrey. "Competitive Viability in Banking: Scale, Scope, 

and Product Mix Economies." Journalof'Monetary Economics 20 (1987):501-20. 

Berger, Allen N., and David B. Humphrey. "The Dominance of Inefficiencies over Scale and Product Mix 

Economies in Banking." Journal of Monetary Economics 28-1 (1991): 117-48. 

Cebenoyan, A. Sinan. "Multiproduct Cost Functions and Scale Economies in Banking." Financial Review 23 

(1988):499-512. 

Fields, Joseph A., and Neil B. Murphy. "An Analysis of Efficiency in the Delivery of Financial Services: The Case 

of Life Insurance Agencies." Journal ofFinancial Services Research 2 (1989):343-56. 

Horvitz, Paul M. "Economies of Scale in Banking." In Deane Carson and Paul H. Cootner, editors, Private 

Financial Institutions, pp. 1-54. Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1963. 

Humphrey, David B. "Cost Dispersion and the Measurement of Economies of Scale in Banking." Federal Reserve 

Bank of Richmond Economic Review 76 (1987):38-5O. 

, "The Likely Effects of Interstate Branching on Bank Costs and Services." Washington, D.C.: U.S. 

Congressional Budget Office, 1991. 

Hunter, William C. and Stephen G. Timme. "Technical Change, Organizational Form and the Structure of Bank 

Production." Journal ofMoney, Credit andBanking 18 (1986):152-66. 

Kolari, James, and Asgh-ar ZatdkoohL Bank Costs, Structure, and Performance. Lexington, MA: D.C. Heath and Co, 

1987. 

Longbrake, William E., and John A. Haslem. "Productive Efficiency in Banking: The Effects of Size and Legal 

Form of Organization on the Cost of Producing Demand Deposits." Journalof'Money, Credit and Banking 7 

(1975):317-30. 

Murphy, Neil B. "One-Stop Financial Service Delivery Opportunities in a World of Automated Self-Service 

Banking: Some Evidence from the United States." In E. P. M. Gardener, editor, The Future of Financial 

Systems and Services. London: Macmillan and Co., 1991. 

Murphy, Neil B. and Yair E. Orgler. "Cost Analysis for Branching Systems: Methodology, Test Results and 

Implications for Management." Journal ofFinancial Research 5 (1982):181-87. 

Murphy, Neil B. and Ronald C. Rogers. "Life Cycle and the Adoption of Consumer Financial Innovation: An 

Empirical Study of the Adoption Process." Journal of Bank Research 17 (1986):3-8. 

Nelson, Richard W, "Branching, Scale Economies, and Banking Costs." Journal of Banking and Finance 9 

(1985):177-92. 

Pavlopoulos, P. G., and A. K. Kouzelis. "Cost Behavior in the Banking Industry: Evidence from a Greek 

Commercial Bank." Applied Economics 21 (1989):285-93. 

Siems, Thomas F. "Quantifying Management's Role in Bank Survival." Federal Reserve Bank of Dallas Economic 

Review (First Quarter 1992):29-41. 

31 
32 
33 
FDIC Banking Review 

=ceot Developments 

Affecting 

Imstl n\ 

by Benjamin B. Christopher* 

Regulatory Agency Actions 

Inter-Agency Actions 

Federal Bank and Thrift 

Regulatory Agencies' 

Joint Actions 

The federal bank and thrift regu 

latory agencies are engaging in joint or 

coordinated efforts in several regu 

latory areas, including: a) standards for 

banks1 and thrifts' safe-and-sound 

operations; b) "prompt corrective ac 

tion" requirements; c) identifying in 

stitutions with high interest-rate risk; 

d) real-estate lending standards; and 

e) coordination and communication 

between external auditors and ex 

aminers. These are summarized under 

the FDIC section in this Review. Also 

see the discussions under other regu 

latory agencies and the Federal Finan 

cial Institutions Examination Council 

(FFIEC). 

Federal Deposit Insurance 

Corporation 

Recapitalization of the 

Bank Insurance Fund 

As required by Section 7(b) of the 

Federal Deposit Insurance Act, 

amended by the FDIC Improvement 

Act of 1991 (FDICIA), the FDIC pro 

posed a schedule for increasing the 

reserve ratio of the Bank Insurance 

Fund (BIF) to 1.25 percent over a 

15-year period. Currently, the BIF re 

serve ratio is significantly below that 

level. If the reserve ratio is less than 

1.25 percent, the agency is required tc 

take action to raise the ratio to that 

level. The proposed recapitalization 

schedule specifies a target reserve ratio 

for each semiannual period for the 

next 15 years, culminating in the re 

quisite ratio of 1.25 percent. 

In developing the proposed re 

capitalization, a range of assumptions 

was used for the amounts of failedbank assets and resolution costs, and 

industry growth rates. The FDIC 

noted the uncertainties surrounding 

any schedule based on projections of 

economic conditions beyond the im 

mediate future, and that the 

schedule may require adjustment as 

economic conditions change. FR, 

6I29J92, p. 28810. 

BIF-Recapitalization and 

Risk-Related Insurance 

Fees Adopted 

The FDIC is amending its regula 

tions on assessments to adopt a re 

capitalization schedule for the BIF, 

increase the deposit insurance assess 

ment rate for certain members of the 

BIF or the Savings Association In 

surance Fund (SAIF) during the first 

semiannual period of calendar year 

1993 and thereafter, and adopta tran 

sitional risk-related deposit insurance 

assessment system. 

For the first time, the FDIC will 

charge higher insurance rates to those 

banks and savings associations that 

pose greater risk to the deposit in 

surance funds. Currently, all FDICinsured institutions pay the same 

premium (23 cents per $100 of domes 

tic deposits) under a flat-rate system 

mandated by law. However, more re 

cent laws require the FDIC to raise 

the reserves of BIF and SAIF, imple 

ment a risk-related premium system, 

and adopt a long-term schedule for 

recapitalizing the BIF. FDICIA man 

dates that a risk-related assessment 

system be implemented no later than 

January 1, 1994. Under the new rule, 

which goes into effect January 1,1993. 

a bank or thrift will pay within a range 

of 23 cents per $100 of domestic de 

posits to 31 cents per$100 of domestic 

deposits, depending on its risk clas 

sification. The system to start this 

coming January is intended to provide 

for a transition between the current 

flat-rate system and the final risk-re 

lated premium system to be imple 

mented in 1994. Although the new 

risk-related system and rate schedule 

were adopted as final, the FDIC 

Board will meet again later this year to 

'Benjamin fl. Christopher is a financial 

economist in the FDIC's Division of Research 

and Statistics. 

Reference sources: American Bunker (AB); 

Wall'Strstl Journal'(WS,}),V,N 

(BBR): and Federal' Register (FR). 

34 
Recent Developments 

consider whether changes in economic 

or industry conditions would warrant 

adjustments in the range of assess 

ment rates to he charged in January. 

To arrive at a risk-related assess 

ment for each bank and thrift, the 

FDIC will place it in one of nine risk 

categories using a two-step process 

based first on capital ratios and then 

on other relevant information. Each 

institution will be assigned to one of 

three groups (well-capitalized, ade 

quately capitalized, or undercapital 

ized) based on its capital ratios. These 

capital definitions are identical to 

those being used by the four federal 

bank and thrift regulators for use in 

the "prompt corrective action" regu 

lation separately adopted, except the 

premium rule excludes references to 

supervisory evaluations and directives 

that are included in the other regula 

tion. Each institution will be assigned 

also to one of three subgroups based 

r>n evaluation of the risk posed by the 

institution. The FDIC will make this 

evaluation based on reviews by the 

institution's primary federal or state 

supervisor, statistical analyses of finan 

cial statements and other information 

relevant to gauging the risk posed 

by the institution. These supervisory 

evaluations therefote will modify the 

premium rates within each of the three 

capital groups, the result being nine 

risk categories, with assessment rates 

ranging from 23 cents (per $100 of 

domestic deposits) to 29 cents for wellcapitalized institutions, 26 cents to 3C 

cents for adequately capitalized in 

stitutions, and 29 cents to 31 cents for 

undercapitalized institutions. 

The FDIC projects that about 75 

percent of the 12,000 BIF-insured 

commercial banks and savings banks 

(with 51 percent of the deposit base) 

and 60 percent of the 2,300 SAIF-in

sured thrifts (with approximately 43 

percent of the deposit base) will be in 

the lowest-rate-paying group when 

the new system stans in January. 

Only about 220 banks (two percent of 

all insured commercial and savings 

banks) and 160 thrifts (seven percent 

of all insured thrifts) are expected to 

be in the group paying the highest 

insurance rate. PR-129-92. FDIC, 9/15/92; 

FR, 10//,p. 4526.1 

Midyear 1992 

Financial Results 

The BIF had net income of ap 

proximately $1.5 billion (preliminary) 

for the six months ended June 30. 

1992. As a result, the unaudited fund 

balance improved to a negative $5.5 

billion from the year-end 1991 level of 

a negative $7 billion. The major factor 

contributing to earnings was a 

favorable interest-race environment, 

which led to an upwatd adjustment to 

expected values on failed-bank assets 

in liquidation. On a current basis, in 

surance costs continue to exceed as 

sessment income. The BIF's 

operating expenses and insurance los 

ses for the first six months of the year 

totaled about $3.3 billion, compared 

to assessment income of about $2.8 

billion during the period. This con 

tinues a pattern that began in 1984 

where, on a current basis, actual costs 

have exceeded assessment revenue 

each year. The aggregate assessment 

revenue shortfall from January 1984 

through June 1992 amounts to approxi 

mately $18 billion. 

Acting Chairman Andrew C. Hove, 

Jr. said that working capital borrow 

ings from the Federal Financing Bank, 

which are repaid from asset sales, in 

creased by $4.5 billion to a balance of 

$15.5 billion. To date, the FDIC has 

not borrowed any of the $30 billion 

available from the U.S. Treasury tc 

cover operating and insurance losses 

related to bank failures. 

For Che year 1991, the BIF had 

revenues of about $5.8 billion, an in 

crease from $3.9 billion the previous 

year. However, insurance losses and 

operating expenses (including $15.4 

billion foi unresolved bank failures) 

totaled nearly $16.9 billion. This re

sulced in an $11.1 billion net operat 

ing loss, that reduced the BiF balance 

from $4.0 billion at year-end 1990 co a 

deficit of $7.0 billion at year-end 1991. 

The FDIC handled 124 BIF-insured 

bank failures in 1991 with record-high 

assets of $63.1 billion, and also 

provided financial assistance to three 

small banks in danger of failing (total 

assets of $83.8 million). 

Sixty-six banks with assets nf ap 

proximately $20.1 billion failed 

during the first half of 1992. The 

estimated costs to the BIF from those 

failures is about $3.1 billion. Despite 

the increase in the fund balance at 

midyear, che outlook is uncettain. Banks 

and the FDIC are beneficcing from 

che low interest-rate environment in 

recent months. Acting Chairman Hove 

noted that a large volume of nonper

forming assets remain in banks whose 

future is in doubt. If these banks are 

unable to avoid failure, the BIF's finan 

cial position could deteriorate. PR-86

92, FDIC, 6/2; PR-126-92, 9/9; Annual Report, 

FDIC, 1991. 

Deposit Insurance Coverage 

The FDIC solicited public com 

ment on deposit insurance coverage, 

to assist the agency in complying with 

a provision of FDICIA requiring the 

FDIC to conduct a one-year study of 

the rules that base insurance coverage 

on the "rights and capacities" in 

which deposit accounts are owned. In 

general, under existing rules all 

deposits maintained in the same right 

and capacity {i.e., owned in the same 

manner) in one insured institution ate 

added together and protected up to 

$100,000 in the aggregate. Deposits 

maintained in different rights and 

capacities (such as funds in an in 

dividual account and funds in a joint 

account) are separately insured. 

The FDIC is seeking comments 

on a broad range of issues, including 

the desitability of expanding or limit 

ing the current rules for separate in 

surance coverage. After the review, 

the FDIC may revise the deposit in 

surance rules provided the change 

would protect small depositors, not 

unduly expand deposit insurance 

coverage, and be consistent with the 

insurance provisions of the Federal 

Deposit Insurance Act. FIL-34-92.FDIC, 

511; FR, 4128, p. 17866. 

Standards for Banks' and 

Thrifts' Operations 

The FDIC and the three other 

federal bank and thrift regulatory 
FDIC Banking Review 

agencies are seeking public comment 

on a broad range of issues for judging 

safe-and-sound operations of insured 

depository institutions. The agencies 

are required by FDICIA to prescribe 

certain safety and soundness stand 

ards for insured institutions and their 

holding companies in three main areas: 

1) operations and management; 2) asset 

quality, earnings and stock valuation; 

and 3) employee compensation. Final 

regulations must be issued no later 

than August 1, 1993, and be effective 

no later than December 1, 1993. 

Because of the range and complex 

ity of these issues, the agencies first 

are seeking responses from the public 

to more than 50 questions. Based in 

part on the comments received, the 

agencies next plan to develop a pro 

posed regulation that will be issued 

for additional public comment. The 

four agencies intend to work together 

reviewing all comments and develop 

ing joint proposals and final rules. FIL

55-92, FDIC, 7122; FR, 7fl5,p. 31336. 

"Prompt Corrective Action" 

Requirements 

The FDIC adopted a final rule, co 

become effective December 19,1992. 

implementing a statutory requirement 

that banking regulators take specified 

"prompt corrective action" when an 

insured institution's capital falls to cer 

tain levels. Similar rules have been 

adopted by the Federal Reserve Board 

(FRB) and are in the process of being 

adopted (as of 9/15/92) by the Office 

of the Comptroller of the Currency 

(OCC) and the Office ofThrift Super 

vision (OTS) for the institutions they 

supervise. FDICIA provides that re 

strictions and prohibitions on an in 

sured bank or thrift are to become 

more severe as the institution's capital 

level declines. The sanctions begin 

with measures such as restrictions on 

dividends and management fees (if 

the payments would result in the in 

stitution becoming undercapitalized) 

and ultimately result in the closing of 

institutions that are critically under 

capitalized. The FDIC's rule applies 

primarily to state-chartered banks and 

insured branches of foreign banks that 

are supervised by the agency, as well 

as to directors, officers and employees 

of these institutions. However, por 

tions of the FDIC rule also apply to all 

insured depository institutions that are 

deemed to be "critically undercapital 

ized." 

Under the new rule, a "well-capital 

ized" institution is defined as having 

a total risk-based capital ratio (the ra 

tio of total capital to risk-weighted 

assets) of at least ten percent, a Tier 1 

risk-based ratio (the ratio of Tier 1 or 

"core" capital to risk-weighted assets) 

of at least six percent, a leverage ratio 

(the ratio of Tier 1 capital to total 

assets) of at least five percent, and it is 

not subject to any written agreement, 

order or directive from its regulator to 

meet and maintain a specific capital 

level. 

Other capital categories in the new 

rule are "adequately capitalized," 

"undercapitalized," "significantly un 

dercapitalized," and "critically under 

capitalized." FDICIA mandates that an 

undercapitalized institution be subject 

to restrictions on dividend and manage 

ment fees, asset-growth restrictions, and 

prohibitions against makingacquisitions, 

opening branches, or engaging in new 

lines of business without the prior ap 

proval of its primary federal regulator. 

Significantly undercapitalized institu 

tions are subject to the restrictions that 

apply to undercapitalized banks and 

thrifts, as well as to other limitations 

that include mandatory prohibitions 

against the payment of bonuses and 

raises to senior executive officers with 

out the regulator's prior approval. Criti 

cally undercapitalized institutions are 

subject to the restrictions that apply to 

the other two categories of undercapi 

talized institutions, as well as to other 

prohibitions that the FDIC has been 

given authority to enforce as the insurer 

of deposits. Under FDICIA, a critically 

undercapitalized institution generally is 

prevented from paying principal and 

interest on its subordinated debt and 

will be placed in conservatorship or re 

ceivership if its capital level is not in 

creased within a prescribed time limit. 

The FDIC estimates that about 98 

percent of the nation's 12,000 insured 

banks (commercial and savings) and 

90 percent of the 2,000 insured thrifts 

have capital levels fitting the statisti 

cal requirements for being well- or 

adequately capitalized. PR-128-92, FDIC, 

9115192. 

Identifying Banks with High 

Interest-Rate Risk 

The FDIC is seeking public com 

ment on a proposed new system for 

identifying banks that face excessive 

risk from swings in market interest 

rates. The proposal, still in its early 

stages of development by the three 

federal bank regulatory agencies, 

would require certain banks with high 

levels of interest-rate risk to increase 

their capital to cover their "excess" 

exposure to loss. FDICIA requires 

the federal banking agencies to revise 

existing risk-based capital standards 

to take adequate account of interestrate risk. final rule must be publish 

ed by June 19, 1993. The regulators 

estimate that when a final rule is 

adopted, approximately 20 percent of 

the nation's commercial banks could 

face an additional minimum capital 

requirement as a result of high inter 

est-rate risk exposure. 

The plan is to expand the quarterly 

financial reports filed by FDIC-insured 

banks to give a more detailed account 

of the assets and liabilities scheduled 

to mature or undergo interest-rate 

adjustments in the future. This would 

include more information on interestrate swaps, futures contracts and other 

off-balance-sheet items. A formula 

would project and quantify the effects 

of a 100-basis-point change in interest 

rates. A bank identified as having a 

high level of interest-rate risk would 

be required to cover its projected ex 

cess exposure with a proportional 

amount of capital. 

The FDIC and the other 

regulatory agencies are seeking to 

balance the need for additional infor 

mation with concerns about limiting 

paperwork and other burdens on the 

industry. As such, the agencies are 

asking for suggestions about how to 

implement an exemption for institu 

tions clearly identified as having low 

interest-rate risk. The agencies also 
Reccnc Developments 

are seeking general input about im 

plementing other provisions of the 1991 

law that address the risks from con 

centrations of credit and from non

traditional activities. 

Based on the comments received, 

the agencies will issue a proposed regu 

lation for another round of public com 

ment before issuing a final rule. The 

plan issued by the FDIC applies only 

to state-chartered banks that are not 

members of the Federal Reserve Sys 

tem. It is identical to what is being 

developed by the RB and the OCC for 

the banks they regulate, pr-iw-92, FDIC, 

7/29; FIL-60-92, FDIC, 8120; FR, 8110, fi. 35507. 

Real-Estate Lending 

Standards 

FDICIA requires the four federal 

bank and thrift regulatory agencies to 

adopt uniform real-estate lending stan 

dards by September 19, 1992, to be 

come effective on March 19,1993. To 

implement this requirement, the regu 

lators issued for public comment a joint 

proposal. It includes a plan to establish 

loan-to-value (LTV) ratio limitations on 

real-estate loans as a suitable standard 

for addressing lending risk. The agen 

cies are asking for comment on two alter 

native approaches. 

Alternative 1 would require each 

institution's board of directors to es 

tablish its own prudent lending stand 

ards for six categories of real-estate 

loans, subject to a range of maximum 

permissible LTV ratios proposed by 

the agencies. For example, the agen 

cies have proposed that loans for raw 

land have a maximum permissible LTV 

ratio in the range of 50-to-65 percent, 

and that each institution be required 

to set its own maximum ratio within 

or below that range. After establishing 

maximum LTV ratios for each cate 

gory of real-estate lending, each lender 

would be expected to specify criteria 

that would be used to qualify loans at 

the institution's established maximum 

LTV ratio levels. The expectation is 

that loans would be made at the upper 

end of the LTV ratio range only when 

significant positive features are pre 

sent that mitigate the higher level of 

risk. Under Alternative 2, the agencies 

would set for all institutions a maxi 

mum LTV ratio for each of the six 

categories of real-estate loans. For ex 

ample, loans for raw land would have a 

maximum LTV ratio of 60 percent, 

and all lending institutions regulated 

by the agencies would be subject to 

that maximum. For either alternative, 

the proposal specifies certain transac 

tions, for example, loans guaranteed or 

insured by the U.S. government or a 

U.S. government agency, that would 

be excluded from whatever LTV ratio 

limitations are adopted in the final rule. 

Under the proposal, lenders would 

be authorized to make real-estate loans 

in excess of LTV limits if the ag 

gregate of those loans does not exceed 

15 percent of the institution's capital. 

Such loans would have to be reviewed 

by the senior management of the lend 

ing institution, reported to its board of 

directors and adequately documented 

for examiners. FIL-56-92, FDIC, 7122; fr, 

71'16, p. 31594. 

Brokered Deposits 

The FDIC adopted a final rule, 

effective June 16, 1992, implementing 

Section 301 of the FDICIA. Under 

the rule, a "well-capitalized" insured 

depository institution may accept bro 

kered deposits without restriction. An 

"adequately capitalized" insured de 

pository institution is prohibited from 

accepting brokered deposits unless it 

first obtains a waiver from the FDIC. 

An "undercapitalized" institution is 

prohibited from accepting brokered 

deposits. 

A "well-capitalized" institution is 

one that has: a) a ratio of total capital 

to risk-weighted assets of not less than 

ten percent, b) a ratio of Tier 1 capital 

to risk-weighted assets of not less than 

six percent, c) a ratio of Tier 1 capital 

to total book assets of not less than five 

percent, and d) not been notified by its 

appropriate federal banking agency 

that it is in a "troubled condition." An 

''undercapitalized" institution is one 

that fails to meet the minimum regu 

latory capital requirements prescribed 

by its appropriate federal banking 

agency. An "adequately capitalized" 

institution is one that is not a wellcapitalized or undercapitalized in 

stitution. 

An adequately capitalized institu 

tion desiring to obtain a waiver from 

the FDIC must file an application with 

the appropriate FDIC Regional Di 

rector. The final rule provides for a 

60-day transitional period. An adequate 

ly capitalized institution that files an 

application by July 16, 1992, may ac 

cept, renew or rollover brokered de 

posits until August 16, 1992, unless 

otherwise notified by the FDIC. 

An undercapitalized institution may 

not solicit deposits by offering inter 

est rates that are significantly higher 

than the prevailing rates of interest on 

insured deposits in its normal market 

area or in the market area in which 

such deposits would otherwise be ac 

cepted. An adequately capitalized in 

stitution that obtains a waiver to accept 

brokered deposits is prohibited from 

paying an interest rate on these funds 

that significantly exceeds a) the rate 

paid on deposits of similar maturity in 

the institution's normal market area for 

deposits accepted from that area or b) 

the "national rate" (as defined herein) 

paid on deposits of comparable matur 

ity for deposits accepted outside the 

institution's normal market area. 

deposit broker must register with 

the FDIC before it may solicit or place 

deposits with an insured depository 

institution. The broker also must main 

tain certain records, and, upon re 

quest from the FDIC, file quarterly 

written reports. F1L-42-92, FDIC, 613; FR, 

6/5, p. 23933. 

Restrictions on State 

Bank Investments 

The FDIC proposed implement 

ing new statutory restrictions on the 

ability of state-chartered banks to 

own corporate stock and mutual fund 

shares or to have equity ownership in 

other investments such as real-estate 

development projects. 

FDICIA, with certain exceptions, 

prohibits a federally insured statechartered bank from making or retain 

ing equity investments of a type or 

amount prohibited for a national 

37 
FDIC Banking Review 

bank, subject to complete divestiture 

by December 19, 1996. For example, 

since national banks generally are pro 

hibited from owning stock or mutual 

fund shares, the new law prohibits 

these investments for state banks. A 

partial exception is provided if: a) a 

bank had ownership of qualifying 

stocks or mutual funds during the 14

month period from September 30, 

1990, through November 26, 1991, 

and b) the bank's state permitted such 

investments as of September 30, 1991. 

An institution that meets these two 

conditions and wants to retain or ac 

quire new qualifying stock or mutual 

fund shares must provide notice to the 

FDIC of its intention and may receive 

the agency's approval. The FDIC, in 

making its determination, is required 

to look at any significant risk to the 

insurance fund as well as the potential 

impact on the institution's safety and 

soundness. A bank receiving FDIC 

approval to continue making these 

equity investments is subject to an 

aggregate limit under the new law 

equal to no more than the institution's 

capital. The proposal also includes 

the agency's interpretation defining 

the limits on types of investments and 

calculation of the capital limitation. 

An institution with equity invest 

ments not exempted from the pro 

hibition would be required to submit 

to the FDIC a plan to divest such 

holdings as quickly as can be prudent 

ly done. A bank that was lawfully en 

gaging in insurance underwriting as 

principal on November 21, 1991, or a 

bank that had a subsidiary that was 

lawfully providing insurance as prin 

cipal on that date, is exempt from the 

general prohibition on these in 

surance activities but would be re 

quired to give notice of its activity to 

the FDIC. The law also exempts in 

vestments in certain qualifying hous 

ing projects. 

The FDIC also proposed an amend 

ment to its regulations the effect of 

which would be to subject SAIF mem 

ber state banks and BIF member state 

banks to the same restrictions insofar 

as their equity investments are con 

cerned. PR-96-92, FDIC, 6119; FR, 7/9, pp. 

30435,30433. 

Required Annual Audits of 

Banks and Thrifts 

The FDIC will seek public com 

ment on a proposal to implement new 

statutory requirements for outside au 

dits of insured institutions and other 

measures to detect and prevent pro 

blems in a bank or thrift's Financial 

management. FDICIA requires each 

insured institution with total assets of 

$150 million or more to file with the 

FDIC annual financial statements au 

dited by an independent public ac 

countant, although the agency has the 

authority to raise the $150 million thres 

hold. The accountant also must review 

and attest to the effectiveness of the 

institution's internal controls and its 

compliance with safety and soundness 

regulations, using audit procedures 

greed upon by the FDIC. Among other 

requirements, an institution subject 

to this law must establish and main 

tain an audit committee composed en 

tirely of outside directors who must 

review the audit findings with man 

agement and the outside accountant. 

Audit committees of "large institu 

tions" have more stringent require 

ments. 

The $150 million-level, which 

would cover about 3,000 of the na 

tion's 14,000 FDIC-insured banks and 

thrifts, is being proposed because it is 

consistent with the FRB regulations 

for bank holding company audits and 

because most institutions of that size 

already get outside audits. In addi 

tion, banks and thrifts with assets of 

$500 million or more would be con 

sidered "large" under the proposal and 

therefore subject to more stringent 

audit committee requirements. 

Those include a prohibition against 

large loan or deposit customers serv 

ing on the audit committee and a re 

quirement that the committee have 

access to its own outside counsel in 

dependent of management. Auditors 

would be required to meet certain qual 

ifications, including independence 

from the institution, and being en 

rolled in an accounting industry peer 

review program. 

In general, the FDIC is attempting 

to implement the law and maximize 

the benefits to the agency but also to 

limit the compliance costs for banks 

and thrifts. The law requires the new 

auditing system to be in effect for the 

first fiscal year after December 31, 

1992. PR-124-92, FDIC, 911; FR, 9il5,p. 42516. 

Coordination and 

Communication Between 

External Auditors and 

Federal Examiners 

The FDIC, FRB, OCC, and OTS 

adopted a policy statement intended 

to improve the coordination and com 

munication between external auditors 

and federal examiners. The statement 

clarifies and makes uniform the agen 

cies' guidelines regarding the infor 

mation a depository institution should 

provide to its external auditor and cir 

cumstances under which external audi 

tors may attend meetings between 

examiners and an institution's man 

agement. Although this policy state 

ment applies to banks and thrifts, the 

guidance also may be appropriate for 

FDIC-supervised insured branches 

of foreign banks and their external 

auditors. 

Topics discussed in the statement 

are: a) coordination of external audits 

and examinations, b) reports and su 

pervisory documents to be provided 

by a depository institution to its external 

auditors, c) external auditor atten 

dance at meetings between manage 

ment and examiners, d) meetings and 

discussions between external auditors 

and examiners, and e) confidentiality 

of supervisory information. FIL-57-92, 

FDIC, 1124. 

New Minimum Standards for 

International Banking 

Supervision 

The FDIC joined with regulators 

in the U.S. and 11 other industrialized 

nations, which included Japan, 

Canada, and nine western European 

countries, on new minimum stand 

ards for authorizing and supervising 

international banking operations. The 

joint agreement is intended to im 

prove international supervision and 

coordination in light of a number of 

recent developments, including the 

38 
Recent Developments 

widespread fraud and financial 

troubles at the failed Bank of Credit 

and Commerce International (BCCI). 

The Basle Committee on Banking 

Supervision, of which the FDIC is a 

member, reaffirmed previouslyadopted principles for international 

supervision but under stronger mini 

mum standards that each of the 12 

nations on the committee will be ex 

pected to observe. In addition, the 

Basle Committee agreed to encour 

age banking supervisors from other 

nations to endorse these standards. 

The minimum standards seek to 

ensure that every bank with opera 

tions in more than one country will be 

subject to effective, consolidated over 

sight by a single supervisor while still 

taking into account the legal and struc 

tural differences among the countries. 

The agreement includes provisions 

that consolidate the supervision of a 

bank or banking group's inrernational 

activities under a single regulator and 

ensure that this regulator will have 

access to information about the insti 

tution's activities in other countries. 

Of special interest to U.S. banking 

agencies is that the agreement recog 

nizes that a country may restrict or 

prohibit a foreign bank's operations 

within its borders if its regulator be 

lieves that the bank's home-country 

regulator is not meeting the new min 

imum standards for effective consoli 

dated supervision. PR-106-92, FDIC, 7/6. 

Court Upholds Director and 

Officer Lawsuits 

Overturning a lower-court decision, 

the U.S. Court of Appeals for the 10th 

Circuit in Denver affirmed that the 

FDIC in suits against bank officials 

must prove only simple negligence, 

rather than gross negl igence. The deci 

sion, by the full appeals court, involved 

former directors of the failed Tracy 

Collins Bank and Trust Co. of Salt 

Lake City. The FDIC's case was based 

on enforcement powers granted by 

the Financial Institutions Reform, Re 

covery, and Enforcement Act of 1989 

(FIRREA). AB,6/29/92,p. I. 

Survey Finds Real-Estate 

Recovery Continues, 

But Is Slowing 

The FDIC's latest survey of realestate conditions, which was released 

in late July, indicates that the recovery 

is continuing but had slowed since the 

previous survey in May. In the com 

mercial sector, many respondents still 

reporred excess office space and low 

demand in their local markets. In 

general, while positive views of recent 

developments in both residential and 

commercial reaUestare markets out 

numbered negative ones, the assess 

ments were less favorable than in the 

previous survey, which had found a 

sharp improvement in both residen 

tial and commercial real-estate 

markets in all regions of the country. 

The surveys began in April 1991, 

and are based nn interviews across the 

country with nearly 500 senior exam 

iners and liquidation personnel at 

federal bank and thrift regulatory 

agencies. composite of survey find 

ings about the residential and com 

mercial real-estate markets is used to 

compile an overall index. Values of 

the index above 50 indicate that more 

respondents believed conditions 

were improving than declining, while 

values below50 indicate the opposite. 

In this latest survey, the index fell to 

63 from the high of 72 in May. 

In residential markets, 51 percent 

of the respondents nationwide cited 

better local housing conditions during 

the previous three months, than in 

May. Only ten percent thought hous 

ing markets had declined. As in the 

May survey, excess housing supply 

was lower and more areas had average 

or above-average home sales compared 

with earlier surveys. However, the re

porrs about commercial markets were 

mixed. Nearly two-thirds of the respon 

dents said commercial real-estate 

conditions were unchanged from the 

previous rhree months. Another 21 per 

cent cited improvements, but 14 per 

cent reported worsening conditions. 

Regionally, overall market respon 

ses in July were most favorable in the 

South, and weakest in the West. 

During the past year, reports of im 

proving conditions consistently were 

more frequent in the Midwest and in 

the South than in other regions. While 

July assessments in the Northeast were 

less favorable than in May, they con 

tinue to be much improved from ear 

lier surveys. In the West, negative 

reports have outweighed positive 

ones in three of the past four surveys, 

and it is the only region where assess 

ments of commercial real-estate 

developments have not improved. PR

87-92, 6J02; PR-! 18-92, 8127, FDIC; Survey of 

Real Estate Trends, May 1992; July 1992. 

Call Report Preparation 

Survey 

The FDIC sent a questionnaire to 

bankers seeking their input about the 

required quarterly Report of Condi 

tion and Income (Call Report). The 

survey asks for information in three 

general areas: (1) the effort required 

in preparing Call Reports; (2) the 

quality of the FDIC's existing assis 

tance programs, such as the Call 

Report preparation seminars, the tollfree telephone assistance lines, and 

the "Call Report Review" newsletter; 

and (3) suggestions for possible future 

FDIC products or services that would 

further assist bankers in preparing 

Call Reports. 

The FDIC said the voluntary sur 

vey would greatly assist the agency in 

assessing numerous issues involving 

the Call Report. To ensure that each 

bank's response will be kept con 

fidential and to ensure the integrity of 

the data, the Bank Administration In 

stitute (BAI), a professional service 

organization, will process all question 

naires and provide the FDIC with ag 

gregate results only. Aggregate 

statistics also will be provided to the 

FFIEC for possible use in its study of 

Call Report burden issues. The ag 

gregate results of the FDIC survey 

also will be publicly available. F1L-62

92, FDtC, 9111/92. 

Resolution Trust Corporation 

and Thrift Depositor 

Protection Oversight Board 

Operations Update 

Through July 31, 1992, the RTC 

had resolved 652 institutions. The 

agency took 12 institutions into its 

conservatorship program in June, and 

seven in July, bringing to 60 the num 

ber of conservatorship institutions in 

June (end of month) and 66 in July. 
FDIC Banking Review 

The RTC did not close any savings 

associations in June, and closed one in 

July. In the absence of legislation to 

provide additional funding to the RTC, 

the number of conservatorships con 

tinues to grow as potential Acceler 

ated Resolution Program (ARP) cases 

are placed into conservatorship. 

Assets under RTC management in 

June, including both conservatorships 

and receiverships, declined from$l 12 

billion to $111 billion. The reduction 

in assets represented the ongoing sales 

effort by the RTC from its conser 

vatorship and receivership holdings. 

Over the past 13 months, assets under 

RTC management have dropped $57 

billion. The $111 billion of assets under 

RTC management on June 30 con 

sisted of: $13 billion in cash and secur 

ities, $15 billion in performing 1-4 

family mortgages, $25 billion in other 

performing loans, $23 billion in delin 

quent loans, $13 billion in real estate, 

and $22 billion in other assets. 

The 60 conservatorships held $23 

billion in gross assets on June 30, and 

the 651 receiverships held $88 billion, 

excluding from the latter approxi 

mately $15 billion in cash, liquid in 

vestments, and accounts receivable 

accumulated from receivership collec 

tions. Because many of the relatively 

marketable assets have been sold be 

fore an institution enters a receiver 

ship, most of the assets retained by 

the RTC in receivership consisted of 

lower-quality, less-marketable assets. 

Thus, real estate and delinquent loans 

represented 37 percent of receiver 

ship assets. A substantial amount of 

the securities and performing mort 

gages in receivership were junk bonds 

or pledged for secured borrowings or 

substandard loans. 

As of the end of June, RTC resolu 

tions had protected 21.7 million 

deposit accounts from financial loss. 

These accounts had an average ac 

count balance of $9,000. Thrifts closed 

since the start of the RTC held $215 

billion in assets at the time of closure. 

Estimated resolution costs for the 

651 closed thrifts totaled $83.9 billion, 

36 percent of their total liabilities at 

the time of resolution. If the insured 

deposits ofall 651 institutions had been 

paid out to depositors, the estimated 

resolution cost would have been $87.0 

billion. RTC Review, August 1992. 

Separately, the RTC announced the 

successful sale of over 6,996 nonper

forming loans, in 196 loan packages, 

with recoveries of $247.9 million. Over 

163 companies were registered to bid, 

and more than 40 purchased a variety 

of nonperformingloan packages rang 

ing in size from $21 thousand to $22 

million, stratified by collateral type, 

geography, and current book value. 

The auction was conducted in Los 

Angeles as part of a major RTC effort 

to sell its nonperforming loans 

through auctions. Since June 1991, the 

RTC has auctioned in excess of $700 

million in nonperforming loans, and 

more than 15,000 real-estate proper 

ties. News Release, RTC, 9/9192. 

First Resolution Under Pilot 

Marketing Program 

The RTC completed its first resolu 

tion under the agency's pilot Coopera 

tive Institution Marketing Program 

with the sale of Investors Federal Sav 

ings Bank, Richmond, Virginia, to 

Central Fidelity Bank, Richmond. The 

resolution of Investors marked the first 

time that the RTC's primary assetsales initiatives and tools—including 

portfolio sales, securitization, seller 

financing, and due diligence—have 

been employed in one transaction. Un 

der the new marketing program, in 

stitutional investors and asset 

acquirers compete for the acquisition 

of assets at the time of resolution. 

The CIM program provides for 

marketing an institution's deposit fran 

chise along with all of its assets. By 

marketing savings institutions through 

the CIM program, the RTC is able to 

simultaneously solicit bids from pros 

pective asset acquirers and from 

deposit-franchise investors. News 

Re/ease, RTC, 7/10/92, 

Restrictions on Sale 

ofAssets 

The RTC adopted a final regula 

tion which puts restrictions on the sale 

of assets to persons who contributed 

to the failure of a financial institution 

assigned to the RTC or FDIC. The 

regulation, effective August 20, 1992, 

implements provisions of the Compre 

hensive Thrift and Bank Fraud Prose 

cution and Taxpayer Act of 1990. The 

regulation stipulates that the RTC will 

not-sell any asset of an association to an 

individual or to an entity if that in 

dividual or entity's key official(s) par 

ticipated in transactions resulting in a 

substantial loss to that association, was 

removed or barred by a federal agency 

from participating in the association's 

affairs, or misused the association's 

funds. 

Additionally, the RTC will not sell 

the assets of a savings institution to 

any prospective purchaser who, as an 

officer or director of that savings as 

sociation, participated in a material 

way in one or more transactions that 

resulted in an aggregate loss of more 

than $50,000 to that association, or has 

been removed or prohibited from par 

ticipating in the affairs of the savings 

association whose assets are being 

sold, or has demonstrated a pattern or 

practice of defaulting on obligations 

to the savings association whose assets 

are being sold. The regulation also 

makes RTC seller financing unavail 

able to persons or entities under cer 

tain circumstances. 

The RTC also has strengthened its 

procedures for collecting on obliga 

tions due to institutions under its con 

trol. Effective on January 1, 1993, all 

prospective purchasers of RTC assets 

mustcertify that they have no existing 

defaults of $500,000 or more on 

obligations to the RTC or institutions 

under its control. Prospective pur 

chasers must certify also that they 

have no reason to believe that they are 

purchasing assets on behalf of, or for 

resale to, any party which would be 

unable to furnish the certification. 

News Release, RTC, 7/21/92;FR, 7/21,p. 32392. 

Contracting with Firms 

Involved in Lawsuits 

withRTClFDIC 

The RTC adopted a policy state 

ment, effective July 23, 1992, on con 

tracting with firms that are being sued 

40 
Recent Developments 

by it, the FDIC or the Federal Savings 

and Loan Insurance Corporation 

(FSLIC). Generally, the RTCdoes not 

do business with firms that are being 

sued by it, the FDIC or FSLIC. How 

ever, the RTC may do business with 

such firms where the contractor can 

screen the persons and/or office(s) 

charged with wrongdoing from work 

on the RTC contract and the firm 

agrees that it will not use its retention 

by the RTC as a defense in the pend 

ing litigation. Where a contractor is 

subject to multiple lawsuits, or a sin 

gle suit of major proportions, the 

revised policy recognizes that, even 

though individuals and offices can be 

screened from the RTC contracts, con 

tinuing to do business with the firm can 

no longer be justified on fitness and 

integrity grounds under 12 CFR, Part 

1606. A determination under this stan 

dard will be based on the scope and 

breadth of pending lawsuits, total 

mount claimed, and other specified fac 

tors. Press Release, RTC 7120192; FR, 7/23, p. 

32839. 

Minority and Women 

Outreach and 

Contracting Program 

The RTC issued an interim final 

rule, pursuant to FIRREA, to identify, 

promote, and certify eligible firms for 

inclusion in its contracting activities, 

while ensuring that RTC utilizes the 

services of the private sector in a prac 

ticable and efficient manner. The in 

terim final rule was effective August 

10, 1992, and the comment period ran 

to October 9. 

On August 15,1991, the RTC pub 

lished an interim final rule to govern 

the outreach portion of the program. 

That rule also provided standards for 

qualifying as a minority- or womenowned business (MWOB), or minor 

ity- or women-owned law firm, for 

purposes of the program. In Novem 

ber 1991, Congress passed the RTC 

Refinancing, Restructuring, and Im 

provement Ace of 1991 (RTCRRIA) 

which required, among other things, 

that in evaluating contract offers, the 

RTC shall provide technical prefer 

ences of at least ten percent and cost 

preferences of at least five percent to 

MWOBs. Accordingly, this current 

interim final rule incorporates such 

measures. The RTCRRIA also gave 

the RTC authority to adjust the level 

of those preferences as necessary. 

The RTC's outreach efforts to 

minorities and women include out 

reach to potential purchasers of assets 

from savings associations under the 

RTC's control, and to potential ac 

quirers of such savings associations; 

however, the regulation addresses 

only the RTC's contracting program. 

(See this Review, Fall 1991, p. 43; 

Spring/Summer 1992, p. 43). FR, 8/W/92, 

p. 35728. 

Affordable Housing Program 

The RTC issued a final policy 

statement on multifamily properties 

marketed under the Affordable Hous 

ing Disposition Program. Under this 

policy, when more than one multi

family property is purchased from the 

RTC as part of the same negotiation, 

the RTC will require that not less 

than 15 percent of the dwelling units 

in each separate property purchased 

be made available to low- or very-low 

income individuals. FR,8/l9/92,p.3758l. 

Court Rules Failed S&L 

Cannot Shield Assets 

from RTC 

The U.S. Circuit Court of Appeals 

in Richmond, Virginia ruled that a 

failed savings and loan association could 

not prevent its subsidiaries from being 

taken under government control by 

placing them in bankruptcy protec 

tion. The Court removed a prelimi 

nary injunction issued by a federal 

bankruptcy court which blocked the 

RTC from taking control of certain 

resort properties (Landmark Land 

Co. of Oklahoma v. RTC, 8/18/92). 

WSJ, 8120192, p. A2. 

Federal Reserve Board 

Revising Risk-Based Capital 

Guidelines for InterestRate Risk 

The FRB requested public com 

ment on an inter-agency proposal for 

revising risk-based capital standards, 

as prescribed by FDICIA, to incor 

porate interest-rate risk into the 

Board's risk-based capital guidelines. 

Also, comments are sought on me 

thods to implement other requirements 

that risk-based capital standards be 

revised to take adequate account of 

concentration of credit risk, and the 

risks of nontraditional activities. The 

federal banking agencies are required 

by FDICIA to publish final regula 

tions by June 19, 1993. Press Release, FRB, 

7/30/92. 

Corrective Action for 

Undercapitalized Banks 

The FRB issued a final rule to 

carry out the "Prompt Corrective Ac 

tion" provisions of FDICIA (Section 

131). The rule applies to state mem 

ber banks and becomes effective on 

December 19, 1992. The rules 

adopted by each of the federal bank 

ing agencies are substantially the 

same. 

The regulation adopted by the 

FRB: a) defines capital measures and 

the capital thresholds for each of the 

five categories established in the law; 

b) establishes a uniform schedule for 

filing of capital restoration plans by 

undercapitalized institutions and agen 

cy review of those plans; c) clarifies 

aspects of the capital guarantees 

made as part of an acceptable capital 

plan by companies that control an un 

dercapitalized institution; d) estab 

lishes procedures for providing 

institutions with advance notice of a 

proposed supervisory directive and an 

opportunity to contest the directive; 

e) establishes procedures for reclas

sifying an institution to a lower capital 

category based on supervisory factors 

other than capital; f) establishes pro 

cedures by which officers and direc 

tors who are dismissed as a result of an 

agency order may obtain review of the 

dismissal and possible reinstatement. 

Press Release, FRB, 9/18/92. 

Interbank Liabilities 

The FRB issued for comment a pro 

posed new Regulation, F, to imple 

ment a provision of FDICIA, which re 

quires the FRB to develop regulations 

41 
FDIC Banking Review 

designed to limit the exposure of 

insured depository institutions to other 

depository institutions. The proposed 

rule would apply to banks, savings 

associations, and branches of foreign 

banks with deposits insured by the 

FDIC. Those institutions would be 

required to develop and implement 

internal procedures to evaluate and 

control exposure to the depository in 

stitutions with which they do busi 

ness, referred to as "correspondents." 

These procedures would include 

limits on both credit and settlement 

exposure to each individual cor 

respondent. 

The proposed rule also would estab 

lish "benchmark" guidelines for daily 

overnight credit exposure to individ 

ual correspondents within which a bank 

ordinarily would be expected to 

remain. The benchmarks, which are 

based on a measure of credit exposure 

that excludes certain relatively lowrisk transactions, generally would per 

mit an institution to have credit 

exposure to an individual correspon 

dent in an amount up to 25 percent of 

the exposed institution's total capital. 

For a correspondent that an institu 

tion can demonstrate is "adequately 

capitalized," the institution could have 

credit exposure equal to 50 percent of 

its total capital, but no more than 25 

percent of that capital could be ex 

posed through transactions that have 

a term-to-maturity of more than 30 

days. No specific benchmark is 

provided for credit exposure to a cor 

respondent that the exposed institu 

tion can demonstrate is "well

capitalized." In all cases, an institu 

tion would be expected to establish 

prudential credit limits internally, 

either within or in addition to the 

benchmark limits, and would be ex 

pected to place limits on settlement 

and other risks not addressed by the 

benchmarks. FR, 8/20192,p. 31914. 

Truth in Savings 

The FRB adopted a new Regula 

tion, DD, to implement the Truth in 

Savings Act. The Act and Regulation 

require depository institutions to dis 

close fees, interest rates and other terms 

concerning deposit accounts to con 

sumers before they open accounts. 

The Act requires depository institu 

tions that provide period ic statements 

to consumers to include information 

about fees im posed, i nterest earned and 

the annual percentage yield earned. 

Substantive limitations are imposed 

on the methods by which institutions 

determine the balance on which inter 

est is calculated. Rules dealing with 

advertisements for deposit accounts 

are also included. 

The final rule is effective Septem 

ber 21, 1992; however, compliance is 

optional until March 21, 1993. FR, 

9/21/92,p. 43337. 

Revenue Limit on Securities 

Activities ofBHC 

Subsidiaries 

The FRB requested comment on 

alternative methods to adjust the ten 

percent revenue test limiting ineligi 

ble securities activities of Section 20 

subsidiaries of bank holding com 

panies. The current ten percent test 

was designed to prevent Section 20 

subsidiaries from being "engaged prin 

cipally" in underwriting and dealing 

in bank-ineligible securities in viola 

tion of Section 20 of the GlassSteagall Act. 

The FRB's view is that changes in 

the level and structure of interest rates 

since the revenue test was last con 

sidered in September 1989 can alter 

the measure of whether a Section 20 

subsidiary is "engaged principally" in 

ineligible securities in ways that were 

not foreseen. One possible alternative 

test suggested was a revenue test that 

is indexed to interest-rate changes. 

The method of indexing proposed is 

to adjust current interest and dividend 

revenue in order to calcu late the reve 

nue that would have been earned in 

the current period if the Treasury yield 

curve were as it was in September 

1989. 

Under the proposed indexing 

method, current revenue would be 

adjusted by a series of factors supplied 

by the FRB that vary according to the 

average duration of the securities port 

folio. For each duration the factor repre 

sents the ratio of interest rates in 

September 1989 on Treasury securities 

to the average interest rates in the 

most recent quarter. These adjustment 

factors would then be applied to cur 

rent interest and dividend revenue. A 

sample table of adjustments is pro 

vided with the proposal. Press Release, 

FRB, 7/23/92;FR,8/3t,p.33961; 7/29,p.33507. 

Investment Advisory 

Activities ofBank 

Holding Companies 

The FRB amended its interpretive 

rule, effective August 10, 1992, to ex 

pressly provide that a bank holding 

company and its nonbank subsidiaries 

may act as an agent for customers in 

the brokerage of shares of an invest 

ment company advised by the holding 

company or any of its subsidiaries. A 

bank holding company and its nonbank subsidiaries may provide invest 

ment advice to customers regarding 

the purchase and sale of shares of an 

investment company advised by a 

holding company affiliate. 

Bank holding companies engaged 

in these activities are required to make 

appropriate disclosures to customers 

to address potential conflicts of inter 

est or adverse effects. Press Re/ease, FRB, 

7/6/92; FR, 7/9, p. 30387. 

Permissible Nonbanking 

Activities Expanded 

The FRB added full-service 

securities brokerage and financial ad 

visory services to the regulatory list of 

permissible nonbanking activities for 

bank holding companies, effective 

September 10, 1992. The final rule gen 

erally simplifies the conditions pre 

viously imposed by the FRB on the 

conduct of full-service securities bro 

kerage activities and on financial advi 

sory activities. Bankholdingcompanies 

seeking to conduct these activities or 

acquire companies engaged in these ac 

tivities will be able to take advantage of 

a numberof streamlined procedures re 

lating to listed nonbanking activities. 

These procedures substitute a notice 

period in lieu of an application proce 

dure for companies seeking to engage 

de novo in these activities and permit 

Reserve Banks to review proposals 

42 
Recent Developments 

to conduct these activities under 

expedited procedures. Press Release, FRB.. 

8131192; FR, 9110, p. 41381. 

Transactions with Affiliates 

The FRB issued a rule, effective 

September 11, 1992, to exclude from 

Section 23A of the Federal Reserve 

Act transactions between affiliated in 

sured depository institutions that are 

subject to review under the Bank 

Merger Act. The exclusion is in 

tended to reduce unnecessary 

regulatory burden by eliminating the 

need for duplicative federal applica 

tions. Press Release, FRB, 9/4/92: FR 9111, p. 

41643. 

Loans to Member Banks' 

Officials and Principal 

Shareholders 

The FRB adopted revisions to 

its Regulations O and Y, effective 

May 18, 1992, to conform to Section 

306 of FDICIA (see this Review, 

Spring/Summer 1992, p. 45). The 

mendments establish a limit on the total 

amount a bank may fend to its executive 

officers, directors, and principal 

shareholders, and their related interests. 

In general, this limit is equal to the 

bank's unimpaired capital and unim 

paired surplus. For a one-year study 

period, a higher limit will apply to banks 

with deposits of less than $100 million. 

Among other changes, loans to directors 

and their related interests will be subject 

to the same lending limit that now 

applies to executive officers and 

principal shareholders. 

Currently, Regulation O: a) re 

quires a bank's board of directors to 

approve any extension of credit to an 

insider or a related interest in excess 

of a threshold amount (generally the 

higher of $25,000 or five percent of 

the bank's capital and unimpaired 

surplus, up to $500,000); b) prohibits 

any extension of credit on preferential 

terms; c) limits the amount a bank may 

lend to each ofitsexecutiveofficersand 

principal shareholders and their related 

interests; and d) prohibits the payment 

by a bank of an overdraft of an execu 

tive officer or director on an account at 

the bank. 

The amendments also implement 

a reporting requirement relating to cre 

dit extended to executive officers and 

principal shareholders of certain banks 

and bank holding companies. Press Release, 

FRB, 5/7192; 5/22; FR, 5/19, p. 21199; 5128, p, 

22417. 

Changes in Procedural 

Requirements to Reduce 

Regulatory Burden 

The FRB adopted several amend 

ments, effective June 29, 1992, to re 

duce unnecessary regulatory burden. 

One revision increases the size of nonbank companies that can be acquired 

by bank holding companies under 15

day expedited notice procedures. 

Bank holding companies (subject to 

other criteria) will be permitted to ac 

quire nonbank companies where nei 

ther the book value of the assets to be 

acquired nor the gross consideration 

paid for the assets exceeds the lesser 

of $100 million or five percent of the 

applicant's consolidated assets. 

The relative size of nonbank assets 

that can be acquired by bank holding 

companies in the ordinary course of 

business without prior FRB approval 

is increased. Abank holding company 

may, under certain circumstances, ac 

quire nonbank assets in the ordinary 

course of business without filing an 

application if the assets to be acquired 

relate to activities that the bank hold 

ing company has previously received 

approval to conduct. Currently under 

the FRB's interpretation, the book 

value of the assets to be acquired can 

not exceed 20 percent of the book 

value of the assets of the applicant in 

the same line of activity. The revision 

expands the relative size criteria to 50 

percent. 

The amendments waive certain re 

quirements applying to an acquisition 

by a bank holding company if the trans 

action involves primarily the merger 

of a bank into an existing operating 

subsidiary bank of the acquiring bank 

holding company in a transaction that 

is reviewed by a federal banking su 

pervisor under the Bank Merger Act. 

To qualify for this waiver, several 

criteria are Specified. Press Release, FRB, 

7/2/92; FR, 6/29, p. 28717. 

The FRB approved several chan 

ges in applications procedures, which 

include procedures to limit extension 

of the pre-acceptance period for ap 

plications; offering prospective appli 

cants the opportunity to submit a pre

filing notice of intent to file an ap 

plication; and other changes. The FRB 

also invited comment on any other 

ways in which the burden on appli 

cants may be reduced, consistent with 

the FRB's statutory responsibilities. 

Press Release, FRB, 8125/92; FR, 9/1, p. 39641. 

Subordinated Debt Approval 

Procedure Revised 

The FRB eliminated the require 

ment, effective September 4, 1992, 

that state member banks obtain the 

FRB's prior approval before issuing 

subordinated debt in order to treat 

that debt as capital rather than as a 

deposit. The FRB issued an inter 

pretation of the capital adequacy ap 

pendices to Regulations and which 

provides general guidance on the cri 

teria that subordinated debt and man 

datory convertible debt issued by state 

member banks and bank holding com 

panies must meet to be included in 

capital. Press Release, FRB, 8/28/92. 

Home-Equity Lending 

Disclosure Rules 

The FRB decided not to change 

the rules in Regulation that set forth 

the way creditors disclose discounted 

initial rates and certain payment ex 

amples for home-equity lines. 

The Home Equity Loan Consumer 

Protection Act of 1988 requires credi 

tors to provide consumers with infor 

mation for open-end credit plans 

secured by the consumer's dwelling. 

While Regulation Z does not require 

the stating of the discounted rate in 

the preprinted early disclosures, it re 

quires disclosure of related aspects of 

"teaser rates," including that the ini 

tial rate is discounted and the time 

period the rate would be in effect. 

The second issue involves the statutory 

requirement for disclosure of three types 

of home-equity loan payments, and the 

disclosure of representative examples 

of the various payment options under 

Regulation Z. The approach adopted 

43 
FDIC Banking Rcvjew 

by the FRB for disclosure of the dis 

counted initial rate and certain pay 

ment examples was examined by the 

U.S. Court of Appeals for the District 

of Columbia Circuit in recent litiga 

tion, and remanded to the FRB for 

further consideration. FR, 816192, p. 34616; 

I'2130/91, p. 61'233. 

FRB Allows Thrift 

Acquisition with 

Interstate Branching 

The FRB granted approval for 

BankAmerica Corporation (BAC), 

San Francisco, to acquire the shares of 

HonFed, a Federal Savings Bank, 

Honolulu, which would be merged 

with BAC's wholly owned subsidiary 

federal savings association in Portland, 

Oregon. As a resultof this transaction, 

BAC will operate branch offices in 

Oregon and Hawaii through its sub 

sidiary. While the FRB previously has 

permitted bank holdingcompanies to 

acquire and operate several savings 

associations that each operate in a dif 

ferent state, it is the FRB's first ap 

proval of an acquisition that would 

result in a savings association operat 

ing branches interstate. Press Release, FRB, 

7113/92, with FKB'i Order Approving Acquisition 

of a Savings Association; BBR, 7120, p. 93. 

Availability of Funds and 

Collection of Checks 

The FRB adopted in final form, 

with minor modifications, its interim 

rule amending Regulation CC to con 

form to recent amendments to the 

Expedited Funds Availability Act in 

corporated into FDICIA. The amend 

ments allow banks to extend holds, on 

an exception basis, to "next-day" and 

"second-day" availability checks and 

allow one-time notices of exception 

holds in certain cases. The amend 

ments should benefit and reduce costs 

for all banks that choose to take ad 

vantage of the rule changes. The ef 

fective date is September 14, 1992. 

Regulation CC implements the Act 

and, among other things, establishes 

availability schedules to limit the holds 

banks (including commercial banks, 

savings institutions, and credit unions) 

can place on deposits in transaction 

accounts and requires banks to dis 

close their funds availability policies 

to their customers. The Act and the 

Regulation provide for certain safe 

guard exceptions to the availability 

schedules, whetein the depository 

bank may extend the hold on a de 

posit for a reasonable period of time. 

The exception holds apply to depos 

its to new accounts, daily aggregate 

check deposits in excess of $5,000, 

checks deposited into an account that 

has been repeatedly overdrawn, and 

certain other categories of deposits. 

Prior to FDICIA, most of the excep 

tion holds did not apply to checks that 

must be accorded next-day or secondday availability under the Act and the 

Regulation, such as government, 

cashier's, certified, and teller's 

checks. Press Release, FRB, S11192;FR,8l/4,p. 

36593. 

Withdrawals from 

Priced Services 

The FRB requested comment on 

a proposal by the Federal Reserve 

Banks to withdraw from the priced 

definitive secutities safekeeping ser 

vice by year-end 1993. This proposal 

would eliminate the safekeeping of 

definitive securities pledged to state 

and local governments, but would nor 

affect the safekeeping of collateral 

pledged to the discount window, to 

the Treasury Department, or to U.S. 

government agencies. Secondary mar 

ket purchase and sale of securities, 

which is currently included in the de 

finitive securities service line, will con 

tinue to be offered but will no longer 

be included under this service line 

after 1993. FR, 7114/92, p. 31201. 

The FRB requested comment on 

proposed factors that would be used 

for evaluating Reserve Banks' requests 

towithdrawfromapriced Federal Re 

serve service line. These factors are 

intended to provide a consistent meth 

odology for reviewing withdrawal pro 

posals. Among these factors are: a) it 

is likely that other service providers 

would supply an adequate level of the 

same service (i.e., access, price, and 

quality) in the relevant market(s) if 

the Federal Reserve withdraws from 

the service; b) if other service 

providers arc not likely to provide an 

adequate level of the same service in 

the relevant market(s), it is likely that 

users of the service could obtain other 

substitutable services that could 

reasonably meet their needs; and c) 

withdrawal from the service would 

not have a material, adverse effect on 

the Federal Reserve's ability to pro 

vide an adequate level of other ser 

vices. FR, 7114/92, p. 31203. 

Court Rules on Examiner 

Report Confidentiality 

The U.S. Court of Appeals for the 

District of Columbia reversed a lowercourt decision that gave access to ex 

aminer reports to stockholders suing 

Fleet/Norstar Financial Group, Inc., 

now known as Fleet Financial Group, 

Inc., in Providence, Rhode Island, on 

the grounds that the reports had been 

made available by regulators to the 

bank holding company. The suit in 

volves a claim that Fleet/Norstar 

had failed to maintain adequate 

reserves. 

The appeals court said that five 

factors must be considered in decid 

ing whether the reports must be 

released, including: a) the relevance 

of the documents, b) the availability 

nf other evidence, c) the seriousness 

of the litigation, d) the government's 

role in the litigation, and e) the effect 

of releasing confidential information 

on future communication between 

government officials and banks. 

Whether these factors require that the 

documents be released will now be 

determined by a lower court. WSJ, 

6/30/92,p. B7. 

Office of the Comptroller 

of the Currency 

Prompt Corrective Action 

Directives 

The OCC proposed amendments 

implementing Section 131 of FDICIA 

that requires or permits the federal bank 

ing agencies to take certain supervi 

sory actions when federally insured 

institutions fall within one of five speci 

fically enumerated capital categories. 

It also restricts or prohibits certain ac 

tivities and requires submission of a 

44 
Recent Developments 

capital restoration plan when insured 

institutions become undercapitalized. 

The proposed amendments are nec 

essary to establish the capital levels at 

which insured national banks and in 

sured federal branches will be 

deemed to come within the five capi 

tal categories. The proposals also 

establish procedures for issuing and 

contesting prompt corrective action 

directives, including directives requir 

ing the dismissal of directors and senior 

executive officers. FR, 717192,p. 29808. 

Real-Estate Lending 

Standards 

The OGC and OTS requested 

comments on the costs and benefits 

that are likely to accrue as a result of 

implementing proposed amendments 

to their real-estate lending standards. 

The two agencies specifically asked 

for any available data on the costs and 

benefits of the proposed rule on the 

economy at large. For example, com 

ments were requested on the impact 

on real-estate lending operations at 

depository institutions, including the 

possible reduction in losses on realestate lending; the deposit insurance 

funds; the availability of credit for eco 

nomically sound projects; and on loan 

documentation, monitoring and pro 

cessing time. FR,8/!7/92,p, 36911. 

Risk-Based Capital: 

Residential Construction 

Loans 

The OCG issued a final rule, im

plementinga provision of RTCRRIA, 

and amending the risk-based capital 

guidelines to include in the 50 percent 

risk-weight category certain loans to 

builders to finance the construction of 

presold 1-4 family residential proper 

ties. These loans were formerly weight 

ed 100 percent. The change is effec 

tive October 5, 1992. FR, 913192,p. 40302. 

Branch Closings 

The OCC proposed a guidance to 

national banks regarding branch clos 

ings by those banks and insured fed 

eral branches. A provision of FDICIA 

requires an insured depository institu 

tion to give 90 days' written notice of 

a branch closing to ics federal regu 

lator and to branch customers, to post 

notice at the branch site at least 30 days 

prior to closing, and to develop a policy 

with respect to branch closings. The 

notice to the regulator must include a 

detailed statement of the reasons for 

the decsion to close the branch and 

information in support of those 

reasons. The FRB, FDIC, and OTS 

have developed substantially similar 

positions to those contained in the 

OCC's proposal. There may be some 

procedural differences between the 

agencies' policies. FR, 9/2192,p. 40249. 

Courts Rule on 

Insurance Law 

The U.S. Court of Appeals for the 

Second Circuit said that a 1916 law 

still exists that permits banks in towns 

not exceeding 5,000 in population to 

sell insurance. The New York court's 

decision conflicts with a ruling last 

month of the U.S. Court of Appeals 

for the District of Columbia that Con 

gress had inadvertently repealed the 

small-town exemption in 1918. In the 

case of American Land Title Associa 

tion v. Comptroller Robert L. Clarke, 

the Second Circuit court also ruled 

that national banks located in towns 

of more than 5,000 persons cannot offer 

title insurance. Given this portion of 

the decision, analysts believe that other 

bank insurance activities approved as 

"incidental to banking," including the 

sale of annuities and credit life in 

surance, could be in danger. ABA Bankers 

Weekly, 6/23/92, p. 3; B, 61! 7, p. 3. 

The U.S. District Court in Ken 

tucky ruled that the provision of the 

National Bank Act permitting nation 

al banks in towns of 5,000 or less in 

population to sell insurance continues 

to exist, and directed the state Insur 

ance Commissioner to take applica 

tions from banks in Kentucky that 

qualify. ABA Bankers Weekly, 8/11192,p. 1. 

Closing of Still-Solvent Bank 

Ruled Not a Taking 

The U.S. Claims Court said that the 

closing by the OCC of a still-solvent 

bank was not "a taking" under the Fifth 

Amendment to the U.S. Constitution. 

Following the closure in 1985 of 

Golden Pacific Bank, a suit against 

the OCC was brought by the holding 

company, Golden Pacific Corp., and a 

major stockholder, under the Federal 

Tort Claims Act and the Fifth Amend 

ment. Claimants argued that they were 

entitled to compensation because the 

bank was solvent when it was closed. 

The Claims Court disagreed, stating 

chat "... plaintiffs voluntarily chose to 

invest in the Bank... they were on 

reasonable notice as to what the 'rules 

of the game' were, or reasonably could 

be, in the highly regulated banking 

industry... at those times when the 

government could legally inspect the 

Bank or place it into receivership, plain 

tiffs were unable to exclude the govern 

ment from their property... without 

the right to exclude others, plaintiffs 

do not have the historically rooted ex 

pectation of compensation necessary 

to establish a Fifth Amendment 

taking." BBR,5/l//92,p.S38. 

Court Rules Loan 

Participations Are Not 

Securities 

The U.S. Court of Appeals for the 

Second Circuit, in a two-to-one decis 

ion that affirmed a lower-court decision, 

ruled that loan participations sold by 

banks are not securities, since pur 

chasers are individually in a position 

to watch and protect their investments. 

The loans thus should not be subject 

to the disclosure standards of stocks, 

bonds, and other securities. 

Security Pacific National Bank, now 

a unit of BankAmerica Corp., was sued 

by several financial institutions after a 

borrower defaulted on short-term loans 

sold by the bank and in which they 

participated. The plaintiffs argued that 

Security Pacific should have informed 

them more fully on the borrower's 

financial condition, and also that the 

speed and sophistication of the bank's 

loan participation program made the 

notes more like commercial securities. 

AB, 6/29/92, p. 2. 

Court Limits Accountants' 

Liability 

The New York Appeals Court, 

reversing a lower-court decision, said 

45 
FDIC Banking Review 

an accounting firm was not liable in a 

lawsuit because of insufficient evi 

dence that the firm knew its audit was 

to be used by a bank in making a 

credit decision. In the case, Security 

Pacific Business Credit sued Peat Marwick Main 6c Co. for negligence in 

issuing an unqualified audit opinion 

and financial statement on a company 

which subsequently filed for bank 

ruptcy. The bank said it depended on 

the audit opinion and financial state 

ment in extending a line of credit to 

[he company. The Court said a phone 

call from the bank informing the audi 

tor of its use of the report was not 

sufficient, and also, the audit was not 

performed solely to assist the com 

pany in obtaining a line of credit. ABA 

Bankers Weekly, 7128/92, p. 5. 

Office of Thrift Supervision 

Risk-Based Capital 

Interest-Rate Risk Component. The 

OTS seeks comment on how to incor 

porate an interest-rate risk compon 

ent into the risk-based capital rule. 

The amendment is intended to ensure 

that savings associations maintain 

levels of capital commensurate with the 

degree of interest-rate risk to which 

they are exposed. Under the proposal, 

a savings association's risk-based capital 

requirement would be comprised of 

two components: a credit risk compo 

nent and an interest-rate risk compo 

nent. The agency proposes to measure 

a savings association's interest-rate risk 

exposure in terms of the sensitivity of 

the market value of the portfolio equity 

of an association to changes in interest 

rates. The market value of portfolio equi 

ty is defined as the net present value of 

an association's assets, liabilities, and 

off-balance-sheet contracts. Associations 

with a greater than "normal" level of 

interest-rate risk exposure will be sub 

ject to an "add-on" to their risk-based 

capital requirement 

OTS also will be instituting a sub 

stantially revised data collection form 

thatwillbeused to calculate the inter 

est-rate risk component. Small, highlycapitalized institutions would be given 

the option of filing an abbreviated re 

porting form. NEWS, OTS, 9/2192; FR, 9/3, 

p. 40524. 

Multifamily HousingLoam. RTCRRIA 

provides that first liens of multifamily 

residential properties meeting certain 

prudential criteria and securities col

lateralized by such loans qualify for 

the 50 percent risk-weight category. 

OTS proposes to amend the defini 

tion of "qualifying multifamily 

mortgage loan" to incorporate the cri 

teria set forth in the statute. These 

criteria include the ratio of the prop 

erty's annual net operating income to 

required debt service, the loan's max 

imum amortization and minimum 

maturity, demonstrated timely pay 

ment performance on the loan, and 

other prudent underwriting standards. 

The OTS's proposed rule parallels the 

proposal of the other banking agencies. 

The proposed rule also would ex 

pand the category of privately-issued 

mortgage-backed securities (MBSs) 

that qualify for inclusion in the 50 per 

cent risk-weight category to include 

MBSs that at the time of origination 

are collateralized by qualifying multi

family mortgage loans. NEWS, OTS, 9/2/92; 

FR, 9/2, p. 40143. 

Treatment of Equity Investments. 

OTS proposed that equity investments 

chat are permissible for both savings 

associations and national banks would 

no longer be deducted from savings 

associations' calculations of total capi 

tal over a five-year transition period. 

They would instead be placed in the 

100 percent risk-weight category, the 

same as prescribed by the OCC for 

national banks. Only those equity in 

vestments held by savings associations 

that are not permissible for national 

banks would continue to be required 

to be deducted from assets and thus 

total capital. 

The proposed revisions would not 

increase or in any way affect a savings 

association's underlying authority to 

make such investments. It is noted 

that some equity investments permis 

sible for national banks, such as in 

vestments in foreign banking 

corporations, are not permissible for 

savings associations. The equity invest 

ments currently held by thrifts that 

would be most affected by this change 

are loans with equity participations 

that are considered equity investments 

under Generally Accepted Account 

ing Principles (GAAP). NEWS, OTS, 9/2/92; 

FR, 9/2, p. 40'147. 

General Valuation Allowances 

The OTS requested comments on 

proposed revisions to its guidance to 

savings associations and its examina 

tion staff regarding the appropriate 

levels of general valuation allowances 

(GVAs) savings associations should 

maintain. Associations are required to 

maintain GVAs that are sufficient to 

absorb probable losses not yet iden 

tified in their portfolios. 

Examiners must ensure that asso 

ciations have thoroughly documented 

their process for determining the level 

of the allowances, including analysis of 

all significant factors. The proposed 

policy directs examiners to rely on 

management's estimates of adequate 

GVAs if the association's process for 

determining adequate allowances is 

sound. To guide examiners in eval 

uating the reasonableness of an associa

tion's allowance levels and in 

reviewing associations that do not 

maintain adequate policies, the pro 

posed guidelines set forth quantita 

tive benchmarks as a starting point for 

the determination of appropriate levels 

of GVAs. The guidelines also set forth 

additional quantitative and qualita 

tive factors foranalysis in determining 

the appropriate adjustments to the 

benchmark amounts for the specific 

association. FR, 9/1/92,p. 39736. 

Qualified Thrift Lender Test 

The OTS proposed to revise its 

qualified thrift lender (QTL) regu 

lations to implement provisions of 

FDICIA. Among the statutory chan 

ges, effective in December 1991, were 

lowering the required QTL percent 

age of housing-related investments 

from 70 percent to 65 percent of a 

thrift's portfolio assets, changing the 

computation period, increasing the 

amount of regulatory liquidity ex 

cludable from portfolio assets, and 

authorizing certain shares of the 

stock of certain government-spon 

sored enterprises to be included 

in the computation of qualified thrift 

46 
Recent Developments 

investments. Tmnsmiftal#59,OTSr9/ll/92;FR, 

912, p. 40140. 

Qualified Thrift Lender 

Guidelines 

The OTS implemented the QTL 

provisions of FIRREA in new regula 

tions to provide additional supervi 

sory guidance on investments in 

"starter homes" and "credit-needy" 

areas. In addition, further guidance is 

provided on acquisition, construction 

and development loans and loans on 

mixed-use properties. 

The statute and regulations pro 

vide that savings associations may, sub 

ject to certain conditions, include 200 

percent of the dollar amount of loans 

and investments to purchase, construct, 

or develop starter homes or starter 

home developments in qualified thrift 

investments (QTI). To be classified 

as a starter home loan for QTL pur 

poses, a loan must: a) be secured by a 

1-4 family home, condominium, or co 

operative; or by a development where 

75 percent or more of the value of the 

development consists of such homes; 

b) be located in the association's Com 

munity Reinvestment Act (CRA) com 

munity; and c) be valued at an 

appraised value of 60 percent or less 

than the median value of newly-con 

structed 1-4 family homes in the sav 

ings association's CRA community. 

The statute and regulations also 

authorize savings associations to in 

clude in QTI 200 percent of the dollar 

amount of loans to assist small busi 

nesses or to construct, develop, or im 

prove domestic residential housing or 

community service facilities within 

credit-needy areas. Thrift Bulletin 20-2, OTS, 

6115192. 

Accounting, Reporting 

Requirements Adopted 

The OTS adopted new accounting 

and reporting rules, effective October 

2, 1992, chat will require savings in 

stitutions to tell their customers how 

well they meet capital requirements. 

The final regulation makes the ac 

counting and reporcingrulesforthrifts 

comparable in approach and terminol 

ogy to those for national banks. The 

regulation implements federal laws 

specifying that OTS1 accounting rules 

for savings associations: a) must, as a 

minimum requirement, follow GAAP 

where GAAP is employed by the other 

federal banking agencies; b) may be 

more stringent than GAAP if the OTS 

Director determines that stricter rules 

are necessary for safety and sound 

ness reasons; and c) must be at least as 

stringent as the accounting standards 

imposed on national banks by the OCC. 

As in the past, each savings institu 

tion must publish an annual statement 

of condition in a local newspaper and 

make it or an audited financial state 

ment conspicuously available at the 

association's home and branch offices. 

The new regulation specifies that the 

statement of condition clearly disclose 

the institution's regulatory capital re 

quirement and its actual regulatory 

capital and explain how the public can 

obtain the institution's audited finan 

cial statement. Institutions are given 

three months—up from the current 30 

days—to file their statement of condi 

tion with OTS and make it available 

to the public. 

Among other measures in the new 

regulation, associations will be required 

to maintain a register of all financial 

futures and options contracts that is 

adequate to identify and control these 

activities. Documentation of the ob 

jectives and results of financial op 

tions and hedging strategies must also 

be maintained under the rule. Man 

datory records retention for futures 

and options activities are increased 

from two to ten years. NEWS, OTS, 9/2/92; 

FR, 9/2, p. 40085. 

Regulatory Review 

The OTS proposed to modify or 

delete a number of its regulations, con 

sistent with the President's program 

calling for a review of all federal regu 

lations and policies for the purpose of 

eliminating over-burdensome regula 

tions, and as a result of the agency's 

review process. 

Among the many changes and 

deletions proposed are the following: 

a) Delete the regulation that governs 

the liability growth of savings associa 

tions, which is tied to a capital stand 

ard based on liabilities that were 

removed in 1989. OTS has in place 

asset-growth restrictions based on an 

association's financial health that more 

adequately address safety and sound 

ness concerns; 

b) The agency's recently revised 

"appraisals" regulation sufficiently 

covers the requirements for appraisals 

on all real-estate-related transactions, 

thus savings associations should need 

only to obtain evaluations, not more 

costly appraisals, on real-estate loans 

of $100,000 or less, regardless of loca 

tion; 

c) Delete the requirement that, at 

any one time, the average maturity of 

a federal savings association's port 

folio of corporate debt securities may 

not exceed six years. Capital rules and 

interest-rate risk management policies 

adequately address safety and sound 

ness concerns in this area; 

d) Delete the regulation limiting 

the amount of secured debt that can 

be incurred by service corporations of 

savings associations. These limitations 

are unnecessary because of the con 

solidated capital requirements imposed 

under FIRREA; 

e) Regarding fixed-rate and adjus 

table-rate mortgage loan disclosures, 

delete the requirement for disclosure 

of additional information dealingwith 

due-on-sale clauses, late charges and 

prepayment penalties, escrow pay 

ments, and the notice of maturity for 

non- or partially-amortizing loans. 

Home loan contracts typically contain 

provisions regarding these matters, and 

some of them are referenced in Truth 

in Lending disclosures. Also, the dele 

tion will make OTS' regulations con 

sistent with those of the other agencies. 

NEWS. OTS, 9/3/92; FR, 9/3, p. 40350. 

Thrift Merger and 

Conversion Procedures 

The OTS proposed to significantly 

streamline the process of mergers and 

charter conversions involving feder 

al thrifts and banks. Current OTS 

47 
FDIC Banking Review 

regulations would be amended, im 

plementing sections of FDICIA, to 

allow federally chartered savings asso 

ciations to convert directly to state and 

national banks. The change also 

would permit any insured depository 

institution that qualifies for member 

ship in one of the 12 Federal Home 

Loan Banks and that meets the re 

quirements for a federal thrift charter 

to convert to a federal savings associa 

tion. Under the proposal, all insured 

depository institutions could merge, as 

sume each other's deposits, and trans 

fer assets to each other in exchange for 

assuming deposit liabilities. 

All such actions would be subject 

to new OTS notice or application pro 

cedures. Approval would be required 

by the appropriate federal banking 

agency, generally the agency with pri 

mary jurisdiction over the surviving 

institution. In addition, the resulting 

institution would continue to pay pro 

portionate premiums to both BIF and 

SAIF. NEWS, OTS, 8118192;FR, 8H8tp.37tI2. 

Applications for Interstate 

Branching Approved 

The OTS gave its first approval 

under a rule permitting federally char 

tered thrifts to branch interstate, al 

lowing the $4 billion-asset TCF Bank 

Savings fsb, Minneapolis, to open 

branches in suburban Des Moines, and 

Milwaukee. Prior to the rule, which 

became effective May 11,1992, thrifts 

were permitted to branch interstate 

only by acquiring and converting a 

failed institution, and only if per 

mitted by state law. Under the new 

rule, thrifts must be well-capitalized 

and present viable proposals, includ 

ing market analysis, before their ap 

plications for interstate branches may 

be approved. BBR, 7/20192,p. 108. 

The OTS approved an application 

from the $692 million-asset Investors 

Savings Bank fsb, Minneapolis, to 

convert its agency office in Oakbrook, 

Illinois to a branch. Officials said they 

do not plan to operate the office as a 

full-service branch. BBR, 8124192,p. 257. 

Purchase Approved with 

Qualified Stock Issuance 

The OTS granted approval for 

a holding company of American 

Savings Bank, Stockton, California, to 

purchase $1 million of stock from 

Family Savings Bank, FSB, a Los An 

geles-based minority-owned and 

operated thrift. The purchase, con 

ducted through a qualified stock is 

suance (QSI), is the first action of its 

kind authorized by FIRREA. 

The Act permits a savings associa 

tion that fails to meet minimum, regu 

latory capital requirements to sell stock 

to a savings and loan holding company 

to raise capital. The buyer may pur 

chase up to 15 percent of the insti 

tution's stock and not be deemed to 

be in control of the institution. Family 

Savings' QSI was conducted in ac 

cordance with its approved capital plan. 

An OTS official said the innovative 

use of the QSI enabled a minorityowned and operated institution to ac 

cess capital so that it can continue to 

serve the business and family banking 

needs of customers within its com 

munity. 

The $135.5 million-asset Family 

Savings Bank has two branch offices 

located in Los Angeles and Pasadena. 

American Savings Bank, with $16.9 

billion in assets, has branch offices 

throughout California. NEWS, OTS, 

4110192. 

Outreach Program for 

Minorities, Women 

and the Disabled 

The OTS will actively seek con 

tracts for goods and services from busi 

nesses owned and controlled by 

minorities, women and disabled in 

dividuals. The policy, as mandated by 

FIRREA, would ensure to the maxi 

mum extent possible that businesses 

owned and controlled by members of 

minority groups, women, and the dis 

abled participate in the OTS contract

ing programs. These businesses 

whether large, small or publicly-owned 

should be at least 51. percent owned 

and controlled by members of one or 

more of the designated groups, who 

must either be citizens or permanent 

residents of the U.S. program chair 

person has been appointed. NEWS,OTS, 

9117192; FR, 9117, p. 42906. 

Court Says S&L Rule 

Change Was Contract 

Abrogation 

A U.S. Claims Court judge ruled 

that FIRREA abrogated a contract 

between the government and Glen

dale Federal Bank, a unit of Glenfed, 

Inc. The agreement with regulators 

had allowed the bank to take up to 40 

years to write off $734 million in losses 

of a thrift it acquired in 1981, and to 

report that amount as capital. The 

1989 law abrogated the right of thrifts 

to count "supervisory goodwill" as 

capital, affecting as much as $30 bil 

lion in industry capital. The Court 

said that the government is liable for 

damages or restitution for the mone 

tary losses and loss of business suf 

fered byGlendale. 

In the decision, the judge also ruled 

in favor of two other S&Ls, which are 

now closed, in similar cases. The gov 

ernment is al lowed to appeal the three 

combined cases before the amounts of 

the damages are determined. A total 

of 18 S&Ls have filed such cases in 

the Claims Court. WSJ, 7127192, p. A3. 

OTS, FDIC to Conduct 

Joint Examinations 

The OTS and FDIC agreed to new 

ground rules designed to prevent con 

flicting orders from being issued to 

the nation's savings institutions. The 

agreement establishes procedures for 

the two agencies to jointly conduct 

examinations and resolve inter-agen 

cy disagreements on exam findings 

and appropriate corrective action. OTS 

Director Timothy Ryan said "we need 

to streamline the regulatory process 

and eliminate redundancy and unne 

cessary burdens, particularly concern 

ing examinations. Better coordination 

between the two agencies will enable 

che industry to understand exactly 

what is expected by federal regulators 

in carrying out their responsibilities. 

This will benefit the institutions, 

the examiners and, foremost, the 

depositors." 

Most FDIC savings association ex 

aminations will be performed jointly 

with OTS. Teams from both agencies 

will work together conducting the 
Recent Developments 

examinations, reaching conclusions re 

garding the overall condition of the 

institutions and determining what cor 

rective actions, if any, are required. 

Any inter-agency differences that can 

not be worked out between the OTS 

and FDIC examiners-in-charge at the 

exam site will be forwarded to OTS 

and FDIC regional officers, and if 

necessary to the agencies' Washington 

headquarters. 

Institutions will receive a single re 

port of the examination findings un 

less the two agencies are unable tc 

reach agreement and the FDIC in 

tends to exercise its backup enforce 

ment authority. By using these 

procedures, the agencies expect to re 

solve any differences before exam find 

ings are presented to the management 

and directors of a thrift institution. 

The two agencies also agreed that 

OTS regulations, policies and direc 

tives will be used in reaching exam 

ination conclusions. Findings in the 

examination report will be based on 

GAAP. 

The program is scheduled for all 

Examinations commencing after June 

1, 1992. NEWS, OTS, 5119/92;.Memorandum to 

Regional Directors, FDIC and OTS, 5118. 

Federal Financial Institutions 

Examination Council 

Required CRA 

Documentation Clarified 

The FRB, FDIC, OCC, and OTS, 

in an effort to simplify and streamline 

compliance supervisory processes and 

reduce regulatory burden, issued a 

guidance that clarifies the agencies' 

expectations regarding the documen 

tation that financial institutions 

should maintain to support their per 

formance under CRA. It emphasizes 

that the agencies base their evalua 

tion of CRA performance primarily on 

how well an institution helps meet the 

credit needs of its community or com 

munities, not on the amount of 

documentation it maintains. Also, a 

lack of documentation is not suffi 

cient basis on which to grant a poor 

rating if an institution's performance 

can otherwise be determined to be 

satisfactory or better. 

The agencies expect depository 

institutions to have a well-managed 

program in place to address their 

responsibilities under the law. The 

documentation expected is primarily 

that which is useful to the institution's 

own management needs. The regu 

latory agencies can use this documen 

tation in their assessment of the 

institution's CRA performance. In so 

doing, the agencies recognize that 

CRA-related documentation will gen 

erally be less formal and less extensive 

in small and rural institutions than in 

larger, urban institutions. Press Release, 

FFIEC,6117/92. 

Study of Regulatory Burden 

The FFIEC invited public com 

ment, and planned a series of public 

meetings, in connection with a study 

of the regulatory burden imposed on 

insured depository institutions. Sec 

tion 221 ofFDICIA requires the Coun 

cil to submit to the Congress no later 

than December 19, 1992, a report de 

scribing any suggested revisions to 

regulatory policies, procedures, 

record keeping and documentation re 

quirements that could reduce unnec 

essary regulatory burden on insured 

deposirory institutions. 

In addition to comments generally 

on the nature and scope of regulatory 

burden imposed on depository insti 

tutions, the Council in particular is 

seeking: a) specific suggestions on how 

to comply with particular statutory 

mandates while, at the same time, 

easing the regulatory burden imposed 

on depository institutions; b) alterna 

tive forms, reports, procedures,etc., that 

would simplify institutions' reporting 

and recordkeeping without diminish 

ing compliance with applicable laws, 

or endangering the ability of the agen 

cies to monitor an institution's condi 

tion to ensure safety and soundness; 

c) information regarding the burden 

of regulatory compliance relative to 

the size of the depository institution, 

as well as any appropriate ameliora 

tive measures to ease any undue bur 

den in that regard; and d) any studies 

of regulatory burden concerning de 

pository institutions; particularly, stud 

ies containing quantitative data 

relating to the costs and time attrib 

utable to regulatory compliance tor 

depository institutions, and specifying, 

to the extent possible, those costs/bur 

dens artributable to statutory require 

ments, and those attributable to agency 

discretion. Press Release, FFIEC, 5/14/92; FR. 

5/20, p. 21408. 

Changes in Reporting 

Requirements 

Under the auspices of the FFIEC, 

the four federal banking agencies are 

establishing a uniform policy con 

cerning rhe frequency and timing of 

changes to their regulatory reports. 

These regulatory reports are the Con 

solidated Report of Condition and In 

come (Call Report) filed by insured 

commercial banks and FDIC-super

vised savings banks, the Thrift Finan 

cial Report filed by savings 

associations, the Report of Assets and 

Liabilities of U.S. Branches and 

Agencies of Foreign Banks filed by 

these branches and agencies, and the 

Foreign Branch Report of Condition 

filed by U.S. bank branches located in 

a foteign country, Puerto Rico, or a 

U.S. territory or possession. 

Effective immediately, the agen 

cies will announce prior to the end of 

each year all reporting changes that 

will take effect in the following year. 

The only exceptions to this policy are 

deletions of items from the regulatoryreports and reporting changes re 

quired by statute ot regulation, neces 

sitated by new standards issued by 

accounting standards setting bodies, 

or determined by majority vote of the 

members of the FFIEC to be neces 

sary for safety and soundness, insur 

ance assessment, or other regulatory 

reasons. 

This new formal policy supersedes 

an informal FFIEC policy that, in gen 

eral, had sought to limit changes to the 

bank Call Report forms to once a year 

as of the March 31 report date. Under 

that informal policy, the agencies had 

only committed themselves to give at 

least two months' advance notice of 

49 
FDIC Banking Review 

these reporting changes. The agen 

cies now believe it is appropriate to 

provide for a longer advance notifica 

tion period for changes to the Call 

Report and similar regulatory reports. 

This advance notification policy 

applies not only to the addition of new 

line items to the report forms, but also 

to certain revisions to the instructions 

for the preparation of these regulatory 

reports. Press Release, FF1EC, 5122/92. 

Registry of Licensed 

Appraisers 

The Appraisal Subcommittee 

(ASC> of the FFIEC has established 

a "national registry of state certified 

and licensed appraisers," in accord 

ance with the Privacy Act of 1974. 

Each state appraiser regulatory agen 

cy was notified to submit registry data 

to the ASC, beginning on January 1, 

1992. The system consists of a cen 

tralized, computerized data base of 

files and records concerning individ 

ual state licensed and state certified 

appraisers. Those files and records are 

compiled by each state agency during 

the licensing or certification process 

and also are used by the state agencies 

in monitoring their universe of ap 

praisals and state regulatory standards 

and requirements pertaining to those 

appraisers. FR, 4/1/92, p. 11084. 

National Credit Union 

Administration 

Proposal to Expand 

Business Loans 

The NCUA proposed amend 

ments to permit waivers of the LTV 

requirements for certain loans subject 

to its business loan regulation. The 

agency said the action complies with 

the President's request for federal 

agencies to take certain steps to 

reduce unnecessary regulatory burden 

and foster economic growth, because 

it encourages economic growth by al 

lowing certain credit unions to make 

loans they would otherwise be unable 

to make. 

Currently, business loans are sub 

ject to a LTV ratio of up to 70 percent 

for second liens and up to 80 percent 

for first liens. The limit on a first lien 

is 95 percent if the value in excess of 

80 percent is covered by either a pri 

vate mortgage or equivalent accept 

able insurance. The NCUA believes 

an exemption is warranted if: a) the 

credit union has a proven, successful 

track record in its specific field of busi 

ness lending; b) the credit union or its 

members depend upon this type of 

business lending, meaning that if such 

lending is prohibited it could jeopard 

ize the safety and soundness of the 

credit union or seriously impact on the 

ability of the credit union's members 

to obtain such credit; and c) the credit 

union limits its aggregate exposure to 

this type of lending. 

The exemption would only be 

available to credit unions that had an 

existing business loan program prior 

to January 1,1992. If the exemption is 

granted, the NCUA Regional Direc 

tor may require that the credit union 

submit special monitoring reports of 

this lending activity. FR,5/i5/92,p. 20798; 

ABA Bankers Weekly, 5!26,p. 7. 

Reserves for Loan Losses 

The NCUA proposed amending 

its regulations to modify the valuation 

of the allowance for loan losses to bet 

ter conform with GAAP. This pro 

posed change would require credit 

unions to provide an allowance for 

loan losses sufficient to cover specifi 

cally-identified loans, as well as es 

timated losses inherent in the loan 

portfolio, such as loans and pools of 

loans for which losses are probable but 

not identifiable on a specific loan-by

loan basis. FR, 6130192,p. 29050. 

Definition of "Risk Assets" 

The NCUA proposed changes to 

its regulation defining "risk assets" as 

used to determine federal and 

federally insured state credit union 

reserve requirements. Currently, all 

assets that have a remaining maturity 

of three years or less and are insured 

by, fully guaranteed as to principal 

and interest by, or due from the U.S. 

government, its agencies, the Fed 

eral National Mortgage Corporation, 

the Government National Mortgage 

Association, or Federal Home Loan 

Mortgage Corporation are exempt from 

the definition of risk assets. The pro 

posed change would include in this 

exemption certain assets with matur 

ities greater than three years which 

reset or reprice within one year from 

the date that the calculation of risk 

assets is made, subject to certain restric 

tions. The proposal also clarifies that 

risk assets include loans as well as 

investments, but does not expand be 

yond certain items in the current 

regulation. FR, 5/l/92,p.l8836:6/9,p. 24395. 

Policy Statement on 

Securities Activities 

With certain modifications, the 

NCUA adopted for federal credit 

unions the FFIEC supervisory policy 

statement on securities activities, 

which updates and revises a previous 

statement. The policy addresses the 

selection of securities dealers, requires 

depository institutions to establish pru 

dent policies and strategies for secur 

ities transactions, and defines securities 

trading or sales practices that are 

viewed by the agencies as being un 

suitable when conducted in the in 

vestment portfolio. The statement 

indicates characteristics of loans held 

for sale or trading, and establishes a 

framework for identifying when cer 

tain mortgage derivative products are 

high-risk mortgage securities which 

must be held in either a trading or 

held-for-sale account. FR, 5/27/92, p. 

22157. 

Additional Quarterly Call 

Reports Proposed 

The NCUA proposed an amend 

ment to its regulations to require quar 

terly reporting, phased in over a 

three-year period, by federally insured 

credit unions with over $20 million in 

assets. Credit unions whose assets ex 

ceed $100 million as of March 31,1992, 

$50 million as of March 31, 1993, and 

$20 million as of March 31, 1994, 

would have to file with NCUA a quar 

terly Financial and Statistical Report 

("Call Report"). An agency order is 

sued in January 1992, already has re 

quired credit unions whose assets 

exceed $100 million as of March 31, 

1992 to report quarterly. 

50 
Recent Developments 

Credit unions not affected by the 

schedule will continue to be subject 

to the current requirement of filing a 

semiannual Call Report, FR,8/3/92,p. 34091. 

State Legislation and 

Regulation 

Court Limits Auditors' 

Liability 

California: The state's Supreme 

Court ruled that non-clients of ac 

counting firms cannot sue for alleged 

professional negligence in the course 

af a financial audit, unless they can 

allege fraud or deceit. Non-clients 

may also recover damages resulting 

from violations of federal securities 

laws. WSJ, 8128/92, p. BI. 

Disclosure of Loan Data 

California: new law is designed to 

encourage banks to make emergency 

funds available to South Central Los 

Angeles, following the rioting there. 

Among the several provisions of the 

statute, effective immediately, the 

state for the first time will collect and 

publicly disclose race and gender data 

an business loan borrowers, and will 

disclose also the business location and 

type of business loans granted or 

denied. BBR, 611/92,p. 952. 

Fees on Out-of-State 

Credit Cards 

Delaware: A U.S. court of appeals, 

reversing a district court, ruled that a 

Delaware bank can charge late fees to 

card customers in Massachusetts. 

The case involved Greenwood 

Trust Co., a Delaware subsidiary of 

Scars Roebuck Co., which issues the 

Discover card. Greenwood's agree 

ment with its credic-card customers 

specifies that it is governed by the 

state of Delaware and applicable 

federal laws, under which it imposed 

a $10 charge for late payments. 

Massachusetts' law prohibits late pay 

ment charges on open-end credit-card 

accounts. The appeals court held that 

Section 521 of the Depository Institu 

tions Deregulation and Monetary 

Control Act of 1980 (D1DMCA) 

preempts the state law. BUR, 8/24192,p. 

270; 1114191, p. 735 

New York: Shortly before the 

Delaware decision (above), a district 

court in Minnesota ruled that a bank 

in New York can impose late fees on 

credit cards of customers in Min 

nesota. BBR, 8124/92,p. 210. 

Failed-Bank Records 

Disclosures 

Florida: An amendment to the 

state's banking statutes passed by the 

legislature provides for opening 

records of failed institutions to the 

public within one year after declara 

tion of insolvency. BBR, 6129/92, p. 1138. 

Loan Program for 

the Disabled 

Illinois: Illinois became the first 

state to start a loan program for dis 

abled persons and businesses that are 

complying under the Americans With 

Disabilities Act (ADA), which be 

came effective on July 26. The state 

Treasurer will place deposits with 

participating banks, who will pay 3.75 

percent for the funds which they can 

lend with a three-percent spread. 

Several institutions are offering the 

lOW-rate loans. Bank Utter, 8/3/92, p. 4. 

Low-Cost Checking Account 

New Jersey: The Department of 

Banking issued a proposal for a basic, 

low-cost checking account that 

depository institutions are required to 

offer under a state law enacted in 

1991. The current proposal modifies 

a proposal issued in September 1991. 

Among the features of the basic ac 

count as proposed are: a) no minimum 

balance to maintain the account, b) 

eight free checks per period (about 30 

days), and a maximum charge of 50 

cents for each additional check, c) an 

unlimited number of deposits with 

out charge, and d) a $3 limit on service 

charges per period. 

Holders of the account may be 

charged for check printing, automated 

teller machine usage, and other bank 

ing services at rates no higher than 

those charged on regular checking ac 

counts. BBR, 5111/92, p. 826. 

ATM Security 

New Yori:New York City approved 

automated teller machine (ATM) 

security requirements, including: a) 

surveillance cameras at each location, 

b) better lighting, c) large windows in 

at least one wall at ATM locations, 

and d) mirrors to prevent blind spots. 

Following an 18-month study, banks 

may he required to take other 

specified security measures. New York 

Stale Banker, 8/28/92, p. 3. 

Banks' Selling ofAnnuities 

New York: The state's Supreme 

Court, in deciding against the state 

Banking Department, said that banks 

chartered in New York may not sell 

annuities. The Court is second in the 

state's legal hierarchy to the Court of 

Appeals. 

Texas: A federal district court 

upheld a rule of the OCC allowing a 

subsidiary of a national bank to offer 

fixed- and variable-rate annuities. 

The court found the OCC's decision 

to be reasonable under the "inciden 

tal powers" granted by banking law. 

AB, 7/15/92,p. 2;ABA BantenWeetly, 1/21, p. 5. 

Controls on Charter 

Applicants 

New York: The Governor signed 

the Financial Frauds Prevention Act, 

creating a Criminal Investigations 

Bureau within the state Banking 

Department, and requiring the 

fingerprinting of applicants for bank 

licenses and charters, those seeking to 

incorporate a banking company, and 

applicants for acquiring control of a 

banking organization. The state 

Banking Superintendent is given dis 

cretion—based on reasonable sus 

picion that an applicant has engaged 

in unlawful conduct—on the use of 

the prints to check on whether the 

applicant has a criminal history. BBR, 

813/92, p. 113. 

Interstate Banking 

New York: The Governor signed a 

bill that permits state-chartered banks 

in other states to branch into New 

York on a reciprocal basis. It is the first 

state law specifically authorizing out

of-state bank entry by branching. 

Under the new law, banks branching 

into New York are subject to the same 

branching limits within the state that 

51 
FD1C Banking Review 

apply to New York banks, and may 

exercise the same powers. The state's 

Superintendent of Banking is em 

powered to deny entry to banks that 

do not have an acceptable CRA 

record, and mayexamine a branch of 

an out-of-state bank on the same basis 

as the state's banks, and may issue 

regulations as appropriate. ABA Bankers 

Weekly, 6130/92, p. !O;BBR, 716, p. IS. 

Kansas: A new interstate, recipro 

cal banking statute allows the pur 

chase of Kansas banks by banks 

from Missouri, Oklahoma, Nebraska, 

Colorado, Arkansas, and Iowa, effec 

tive July 1, 1992. Currently, all of 

these states, except Iowa, have laws 

permitting entry of Kansas banks. 

Out-of-state banks and bank holding 

companies applying to buy banks in 

the state must demonstrate safe. 

sound, and prudent operations, and 

must provide a record of adequate and 

appropriate community service, EBK, 

7120/92, p. 106. 

Revised CRA Rules Proposed 

New York: The Banking Depart 

ment proposed major changes in the 

methods for enforcement of CRA that 

would apply to New York's 168 statechartered banks. Coordination with 

federal regulators would be needed. 

The proposed changes include: a) 

numerical targets correlating a bank's 

CRA investments with its level of in 

sured deposits; b) enhanced CRA 

credit for banks that make equity in 

vestments in minority-owned banks 

or maintain branches or ATMs in lowincome areas; c) increased tie-ins be 

tween regulatory applications and 

CRA reviews; and d) exemption from 

application-tied CRA reviews for 

banks that achieve top ratings in three 

consecutive exams. AB, 9110/92,p. 2. 

New Savings Bank Charter 

Wisconsin: A new state law permits 

thrifts in the state to convert to a new 

state savings bank charter. To be 

eligible toconvett, an institution must 

have a capital-to-assets ratio of more 

than six percent. Under the new 

charter, thrifts would be regulated by 

the state Savings and Loan Commis 

sioner and the FDIC, eliminating the 

OTS as a regulator of these institu 

tions. BBR,5/4/92,p. 719. 

Bank and Thrift Performance 

Banks' Earnings Continue 

Uptrend, Asset Growth 

Is Slow 

Earnings of insured commercial 

banks rose to a record $7.9 billion in 

the second quarter of 1992 (prelimi 

nary), up from $7.6 billion in the first 

quarter, and $4.6 billion in the second 

quarter of 1991. The two primary fac 

tors in the improved performance 

were favorable interest-rate condi 

tions, with wider net interest margins 

for the fifth consecutive quarter, and 

a continued decline in loan-loss 

provisions. Net interest income to 

taled nearly $33 billion in the quarter, 

an 8.8 percent increase from the 

second quarter of 1991. Loan-loss 

provisions were $6.3 billion in the 

second quarter, down from nearly $8.3 

billion in the same 1991 period. The 

average return on assets in the second 

quarter was 0.94 percent, the highest 

level since banks began reporting 

quarterly income in 1983. Banks 

limited the decline iiV'gross interest 

income by increasing their holdings of 

residential mortgages and longerterm (over one year) fixed-rate 

securities, and reducing their shortterm investments, including federal 

funds sold. Lower interest expense 

reflected the sharp declines in shortterm rates over the prior twelve 

months, increased equity funding, 

and larger depositor balances held in 

noninterest-bearing accounts. 

Commercial banks' troubled assets 

—mainly non-current loans and 

foreclosed real estate owned— 

declined by $3.3 billion during the 

second quarter, falling to 2.90 percent 

of assets from 3.19 percent on June 30, 

1991. The average ratio declined for 

banks of all sizes and in all regions. 

Asset-quality improvements were 

strongest at banks in the Northeast 

and Southwest Regions, while those 

in the West had the smallest decline 

in troubled assets. 

Assets of commercial banks grew 

by only $2.7 billion in the second 

quarter of 1992, down from an in 

crease of $5.2 billion in the first 

quarter. Totalling $3,438 billion as of 

mid-1992, bank assets were only 1.8 

percent above the level of a year ear 

lier. Loans in the aggregate have been 

shrinking for six consecutive quarters, 

much of this decline being in com 

mercial and industrial~ioans. Among 

the categories that increased in the 

second quarter were adjustable-rate 

home mortgage loans, agricultural 

production loans, and non-construc 

tion commercial real-estate loans. 

Overall, the strongest-growing asset 

continued to be investment secur 

ities, which were $18.6 billion higher 

during the quarter, most of this in 

crease being in U.S. Treasury 

securities and collateralized mortgage 

obligations. 

Commercial banks' equity capital 

rose by $9.3 billion in the second 

quarter, of which retained earnings 

contributed $4,8 billion. Equity capi 

tal now stands at 7.23 percent of assets 

for the industry. By bank asset size, 

the average ratio was 9.39 percent for 

small banks (assets less than $100 mil 

lion), falling to 6.00 percent for banks 

with assets of more than $10 billion. 

By region, banks in the Midwest had 

the highest ratio (8.55 percent), while 

those in the Northeast had the lowest 

(6.43 percent). FDIC Quarterly Banking 

Profile, Second Quarter, 1992. 

Thrifts' Earnings Down in 

Second Quarter 

Savings associations in the private 

sector earned $1.27 billion in the 

second quarter of 1992, down by 18 

percent from the first three months. 

For the first six months, profits were 

a record $2.81 billion. Ninety-three 

percent of private-sector thrifts were 

profitable in the second quarter, the 

industry's sixth consecutive profitable 

quarter. 

A key factor in the industry's 

recovery has been the ongoing cleanup 

of nonviable thrift institutions and con 

solidation through mergers, charter con 

versions and acquisitions. In addition, 

52 
Recent Developments 

the growth in earnings is due to the 

unusually large spread between thrifts' 

cost of funds and their lending rates. 

Gross interest income was down by 

about 20 percent in the second quar 

ter compared to the second quarter of 

1991, while interest expense declined 

by nearly 32 percent, producing a 13 

percent rise in net interest income. 

Thrifts made provision for loan losses 

of $1.25 billion in the second quarter, 

$344 million less than in the same 

period in 1991. 

The thrift industry continues to 

shrink, as the number of private-sector 

savings associations declined in the 12 

months ending June 30, 1992 by 203 

to a total of 2,013 in operation, and their 

assets fell by $80.8 billion to $839.7 

billion. The associations' tangible capi 

tal increased in the period by $4.76 

billion to $46.3 billion. As a percent 

age of tangible assets, the increase was 

from 4.51 percent to 5.49 percent. The 

OTS, in describing a "smaller but 

healthier11 thrift industry, noted that 

the number of thrifts declined by 35 

percent from June 1988 to June 1992, 

and their assets were down by the 

same percentage. In the period, total 

tangible capital of the associations in 

creased from 0.33 percent of assets to 

5.70 percent, while the number of in 

solvent associations dropped from 632 

to 11. Earnings for the six months prior 

to midyear 1988 and 1992 improved 

from minus $8.01 billion (-1.26 per 

cent of assets—annualized) to a positive 

$2.81 billion (0.66 percent of assets). 

As of mid-1992, OTSclassified 982 

thrifts (49 percent of total) in its super 

visory Group I (well-capitalized and 

profitable), 657 (32 percent) in Group II 

(meet or expected to meet capital re 

quirements), 337 (17 percent) in Group 

III (troubled with poor earnings and low 

capital), and 37 (two percent) in Group 

IV (expected to require government 

assistance). NEWS, OTS, 9116192;2ndQuar 

ter 1992 Financial Developments for Private Sector 

Saving Associations, OTS, September 1992. 

Banks Sell Securities at 

Record Level 

Banks sold $11.4 billion in do 

mestic stocks and bonds in the third 

quarter, narrowly surpassing the pre 

vious record of $11.3 billion in the 

preceding quarter. Common stock 

sales were down, falling to $420 mil 

lion from $3.1 billion in the first six 

months. Total debt and equity offer 

ings in the first three quarters of 1992 

amounted to $34.7 billion, up from 

$26.8 billion for all of 1991. 

Banks added $6.1 billion to their 

capital, including $2.5 billion of Tier 1 

capital, in the third quarter. AB, 

10/2/92, p. I. 

Market- Value Accounting 

J.P. Morgan & Go. and Bankers 

Trust New York Corp. said they are 

adopting market-value accounting for 

most of their investment portfolios. 

Traditionally, banks have accounted 

for most investment securities at 

amortized cost. Banks that go to MV 

accounting before it is required are 

showing signs of strength, analysts said. 

An argument against a requirement 

for this accounting is that it could cause 

earnings to fluctuate widely from quar 

ter to quarter. AB, 8/20/92, p. 2. 

Offshore Loans Boost 

Foreign Banks* Share 

of U.S. Market 

Offshore bank loans to U.S. busi 

nesses in the 1980s grew rapidly as 

foreign banks were able to avoid a cost 

of U.S. regulation, which is the 

reserve cost of booking loans in the 

U.S. The largely foreign ownership of 

the banks responsible for the offshore 

lending means that the foreign bank 

share of the U.S. commercial lending 

market is higher than the frequently 

cited 30 percent, which is based on 

loans booked in the U.S. Foreign banks 

have gained a market share closer to 

45 percent, putting commercial lend 

ing ahead of chemicals and automak

ing in the foreign share of the U.S. 

market. 

U.S. banks reported $428 billion of 

corporate loans at the end of 1991, 

while foreign banks had $348 billion. 

Offshore loans to U.S. commercial and 

industrial borrowers—by foreign 

banks in places such as the Cayman 

Islands—had risen to $152 billion by 

the end of the year, up from $20 bil 

lion in 1983. During the same period, 

onshore lending, or loans booked 

through U.S. offices of foreign banks, 

increased to $196 billion from $66 bil 

lion. Onshore and offshore lending by 

U.S. banks rose at a far slower rate, to 

$428 billion from $381 billion in 1983. 

Another conclusion is that more cor 

porate funding was supplied by banks, 

including foreign banks, and less by 

the securities markets than is general 

ly thought. The common perception 

of banks' loss of corporate business to 

the securities markets in the 1980s 

overstates the case. Quarterly Review, Fed 

eral Reserve Bank of New York, Spring 1992, pp. 

52-65; AB, 6/15, p. 1. 

Banks'Holdings of U.S. 

Government Securities 

Exceed Loans 

Banks held $607.3 billion in U.S. 

government securities on June 30, 

1992, according to Federal Reserve 

data, and $598.5 billion in commercial 

and industrial loans, marking the first 

time since January 1965 that U.S. 

securities surpassed business loans 

in banks' portfolios. Critics say that a 

tightening of banks' lending policies 

has been the principal cause for the 

decline in loans. Banks generally at 

tribute the trend more to a lack of loan 

demand related to weakness in the 

overall economy. AB, 7/27/92,p. 1. 

Bank Employment Shrinkage 

Smaller Than Expected 

The number of employees of 

federally insured commercial banks 

fell by about 60,000, or 4 percent, in 

the past five years to just under 1.5 

million at the end of 1991, according 

to FDIC data. The decline has been 

well below the 15 to 20 percent reduc 

tion that some analysts have said is 

necessary to the future competitive 

ness of the industry. 

The employment figures as re 

leased are somewhat distorted by the 

effects of commercial banks' acquisi 

tions of savings institutions which pre 

viously did not report to the FDIC. 

Also, while some mergers and acquisi 

tions of banking institutions have led 
FDIC Banking Review 

to substantial job restructuring, banks' 

retention of employees in different 

job capacities, and the hiring of laidoff technical and other bank employees 

by other banking organizations appar 

ently has been somewhat more pre 

valent than expected. Observers say a 

better test of this development will be 

shown in year-end 1992 employment 

data after the effects of some large 

recent mergers/acquisitions are further 

worked out. AB, 7/1/92,p.3. 

Less Mortgage Credit from 

Deposits in Minority 

Communities 

study by the Association of Com 

munity Organizations for Reform Now 

(ACORN) found that between 1989 

and 1990, for every dollar that banks 

had on deposit in predominantly minor 

ity neighborhoods, they loaned about 

four cents for mortgages in those same 

neighborhoods, while the correspond 

ing amount in white neighborhoods 

was nearly eight cents. The results 

were not significantly different when 

comparing neighborhoods of compar 

able income but with dissimilar racial 

compositions. Middle income, predom 

inantly minority localities received only 

two cents in loans for every dollar of 

deposits, while in white localities the 

figure was seven cents. 

Of the 14 major U.S. cities in the 

study, New Orleans showed the high 

est racial discrepancy, but the com 

parative data were favorable to white 

neighborhoods in every city except 

Philadelphia. 

A spokeswoman for ACORN said 

the study provides new evidence that 

"investment strategies in the banking 

industry are contributing to urban de 

cay and decline." BBR, 618192,p. 988. 

Credit Life Insurance 

Criticized 

study by the Consumer Federa 

tion of America and the National In 

surance Consumer Organization 

concluded that consumers in most 

states are being substantially over 

charged for credit life insurance, and 

disclosures that lenders make to bor 

rowers are inadequate. Nationally, 

credit life policies pay out only 42 

percent of premiums in claims, well 

below the 70 percent the groups said is 

reasonable. Only the District of Co 

lumbia, New York, and Maine, places 

where the product is highly regulated, 

have payout ratios of 60 percent or 

more. Arizona, California, Maryland, 

New Jersey, Oregon, Pennsylvania, and 

Vermont have payouts exceeding 50 

percent. Also, credit unions nationally 

have payout ratios of more than 50 

percent. 

An industry spokesperson re 

sponded that credit insurance does 

not require a medical examination, 

and is considered to be reasonably 

priced in most cases, noting that the 

typical borrower pays only about 

$2.50 per month for coverage. 

The two consumer groups that spon 

sored the study urged states to tighten 

regulations and consumers to exercise 

firmer resistance to offers of the in 

surance. AB, 5/21/92, p. 8. 

Electronic Payments Grow 

Consumers have increased their 

usage of electronic payments over the 

last five years by over 100 percent, 

according to the National Automated 

Clearing House Association. In 1990, 

the number of payments exceeded 

1.5 billion with a value of $6 trillion. 

The number of participants in auto 

matic bill paying for one or more re 

curring expenses such as utilities and 

life insurance premiums has more than 

doubled. Over 25 percent of em 

ployed persons, or about 27 million 

people, now receive their pay via direct 

deposit. Northwestern Financial Review, 4/18/92, 

p. 7. 

Regional Banks to Link 

ATM Systems 

Bane One Corp., CoreStates Finan 

cial Corp., PNC Financial Corp., and 

Society Corp. will combine their auto 

mated teller machines and point-of

sale terminals, subject to approval by 

the Federal Reserve. Anchored by 

CoreStates' Mac system, the joint net 

work, with more than 12,000 ATMs, 

would he the largest in the country by 

some key measures. The move is 

intended to reduce operating costs, 

encourage product development and 

reverse the flow of consumer payment 

processing to nonbank companies. AB, 

7/23/92, p. 1. 

Recent Artidea and Studies 

ABA Study of Regulatory 

i Burden 

The nation's banks paid over $10.7 

billion in 1991 "to keep pace with 

industry rules and regulations/1 ac 

cording to a survey by the American 

Bankers Association. Regulatory costs 

represented about ten percent of the 

industry's total operating expenses, and 

nearly 59 percent of bank profits for 

the year. An official said that banks 

could lend an additional $20 to $30 

billion each year if 25 percent of their 

compliance costs could be added to 

earnings and capital. 

The survey, distributed in Febru 

ary to the ABA's member banks, was 

concerned largely with the time and 

resources that banks devote to com 

pliance. Of the 974 which responded, 

714 had assets of less than $100 mil 

lion, 211 were in the $100 million- to 

$999 million-asset range, and 21 had 

assets of $1 billion or more. Asset size 

was not available in 28 responses. By 

region, the number of respondents 

ranged from 58 in the Northeast to 

367 in the Midwest. The survey and a 

recent ABA public statement were 

used to prepare this article. 

The survey found that CEOs of 

small banks devote eight to nine hours 

per week to regulatory issues, and large 

banks five hours, with an industry aver 

age of about eight hours. Typically, 

compliance issues are discussed at ev 

ery meeting of banks' boards of 

directors, and consume 16 percent of 

a board's time. This figure did not 

vary much between banks in different 

size groups. Small banks pay a higher 

percentage of their operating costs 

and profits on regulatory compliance. 

Their compliance costs as a percent 

age of operating expenses were over 

20 percent, declining to ten percent or 

less for large banks. It is noted that 

nearly 2,000 banks in the U.S. have 

54 
Recent Developments 

ten or fewer employees, and nearly 

half of all banks have 25 or fewer 

employees. 

Seventy percent of respondents— 

many of them community bankers— 

cited CRA as their greatest regulatory 

concern. CRA compliance was first 

among regulatory compliance issues 

causing CEOs the "most headaches," 

and also the most time-consuming. 

Banks complained of regulatory over 

kill in the area of CRA. There is a 

perception that the agencies are put 

ting as much or more emphasis on 

documentation as actual CRA perfor 

mance. Large banks also say that an 

outstanding rating does not protect 

them from C RA protest against a mer 

ger or acquisition application. 

The second most serious complaint 

in the survey from bank CEOs is the 

need for written policies for many bank 

activities. Thirty percentof CEOs cited 

written policies as the most time-con 

suming compliance burden. For front 

line bank staff, filling out currency 

transactions reports is the most timeconsuming. Banks fill out over seven 

million CTRs annually at a cost of 

almost $130 million. It is particularly 

costly, for example, for large urban 

banks that process large numbers of 

commercial deposits. 

Bankers feel that the regulatory 

agencies do not appreciate the extent 

of the burden a rule imposes on their 

institutions. For example, the Paper 

work Reduction Act requires the agen 

cies to measure and report the burden 

created by required paperwork, but 

their estimates of the time required to 

comply with individual regulations are 

said to be much too low. 

The regulatory burden is prevent 

ing some banks from offering certain 

products; for example, many survey 

respondents do not offer adjustablerate mortgages because of the dif 

ficulty and expense involved in 

providing the proper disclosures, and 

stiff penalties that can result from in 

advertent errors. The same comments 

apply to home-equity lines of credit, 

other types of real-estate-based loans, 

and variable-rate consumer loans. In 

respect to not offering certain products 

because of the regulatory burdens, 

small banks in particular mention 

Truth in Lend ing and the Real Estate 

Settlement Practices Act, and in the 

future the Truth in Savings legisla 

tion when that is implemented. 

The effects of the regulatory bur 

den would exist even if banks had no 

nonbank competitors; however, other 

financial and nonfinancial firms are 

free to compete for bank customers 

without the same regulatory impedi 

ments and costs. 

Among a comprehensive set of 

regulatory and legislative changes the 

ABA has recommended are: a) CRA 

relief for community banks, together 

with a safe harbor for all banks earning 

outstanding or satisfactory ratings, 

and relief from the requirement for 

geo-coding of loan applications; b) a 

recognition that small banks do not 

need a multitude of formal written 

policies; c) the growth of required 

Call Report information must be 

restricted; instructions should be sim 

plified; where entire sections do not 

have relevance to an institution, sep 

arate schedules should be utilized 

which need not be completed unless 

certain specified conditions exist; d) 

under the Paperwork Act and other 

legislation, the agencies should 

publish realistic estimates of the im 

pact of a rule proposal, and seek 

public comment on that estimate; and 

e) the agencies should adopt uniform 

applications for mergers and acquisi 

tions, as well as other purposes. Survey 

of Regulatory Burden, American Bankers Associa 

tion, June 1992; Statement of Alan R. Tubbs on 

behalf of ike ABA, FFIEC, 6118. 

Community-hank 

Charter Proposed 

Developments in the thrift and 

banking industries have made the 

"dual banking system" of state and 

federal chartering less important, Gary 

M. Welsh says, while another dual 

system, "community banks" and "com 

mercial banks" is "driving competi 

tion and politics" within the banking 

industry. "Community banks" are 

defined here as the smaller, insured 

depository institutions—thrifts as well 

as banks—that serve primarily cus 

tomers in local areas. The larger in 

stitutions that compete in statewide, 

regional or larger market areas are 

"commercial banks." He states that 

community banks presently are sub 

ject to excessive costs for compliance, 

deposit insurance, and liability, while 

commercial banks are being denied 

the interstate banking and product re 

form which they need to compete with 

nonbank firms and foreign banks. The 

proposal is to create a new federal 

charter for community banks {states 

could also issue such charters). The 

expected benefits would be to reduce 

regulatory burden, and also gain sup 

port across the industry for bank 

powers reform. 

Community banks must have suf 

ficient powers to provide the loans 

needed by consumers, small business 

es, local governments, community or 

ganizations, and other local-area 

customers. With limited geographic 

diversification under the proposal, they 

should have lower lending limits than 

the current national bank limits. In 

sider-lending limits would be eased to 

encourage local participation and di 

rector service in the institutions, 

Community banks would be pro 

hibited from speculative trading but 

could engage in activities necessary 

for effective liability management. 

They could accept all types of de 

posits, but could not accept brokered 

deposits or solicit deposits outside their 

communities. Community banks 

would be permitted to engage in 

"agency" activities, but only in jointventures with local securities, in 

surance, or real-estate firms, and 

under arrangements that would strict 

ly limit a bank's liability. 

Supervisory examinations of com 

munity banks normally would need to 

be conducted less often and in a short 

er time than under the current sys 

tem. The banks would not be subject 

to CRA requirements, but would have 

to comply with all anti-discrimination 

laws. They would be permitted to form 

community bank holding companies, 

which could acquire only community 

banks, including those across state 

55 
FDIC Banking Review 

lines, and could engage in nonbank 

activities closely related to commun 

ity banking. CBHCs could not be ac 

quired by commercial bank holding 

companies or foreign banks. Commer 

cial banking firms would not be al 

lowed to establish de novo banks or de 

novo branches in any rural community 

under 10,000 in population already 

served by a community bank. 

Michael K. Guttau, in responding 

to the new charter proposal, sees seri 

ous disadvantages that result primari 

ly from the restrictions in the charter. 

These negatives are outlined as: a) 

size disincentives, b) strict limitations 

on activities, c) competitive disadvan 

tages, and d) reduction in the value of 

community bank franchises. He pro 

poses, as another way to reduce regu 

latory burden on community banks, a 

"regulatory basket" approach, which 

he says would avoid many of the rigid 

ities and complexities involved in sep 

arate charters. The two proposals are 

similar in some respects. 

All regulations would be reviewed 

to determine which should be applied 

to a bank engaging only in community 

bank activities. Those institutions 

would be subject to the basic basket 

of regulations, while other banks would 

be subject to specific add itional regula 

tions appropriate to their expanded 

activities. For example, the basic regu 

lations might apply to a bank that: a) 

serves only a local area, b) does not 

engage in underwriting or "risky" ac 

tivities, and c) its failure would not 

pose a threat to the economy or the 

deposit insurance fund. The basket of 

regulations that might apply in this 

case could include: a) streamlined 

safety and soundness regulation, b) 

very limited CRA and HMDA rules, 

c) limited financial disclosure and ac 

counting requirements, and d) hold 

ing company would be regulated by 

the same regulator as the bank. For 

each specific area where a bank does 

not meet the criteria for the basic reg 

ulations, a specific additional set of 

regulations would apply. For example, 

if the bank's services are not limited 

to the local area (more than in the 

basic basket), more CRA/HMDA rules 

might apply. If the institution or an 

affiliate engages in the underwriting 

or "risky" activities, another basket of 

safety and soundness regulations could 

be called for, including firewalls, sep 

arate subsidiaries, regulation of the 

umbrella holding company, and func 

tional regulation of nonbanking ac 

tivities. AB, 1111192,p. 4; ABA Banters Weekly, 

5126, p. 3. 

Mixing Banking and 

Commerce 

A recommendation by the 

Treasury Department that commer 

cial firms be allowed to own banks 

failed to be enacted as part of 

FDICIA, and the writer, Loretta J. 

Mester, notes that almost 70 percent 

of senior bank executives recently sur 

veyed were against commercial firms 

owning banks. This article presents 

evidence on both sides of the issue. 

One argument is that expanding 

the field of owners to include com 

mercial firms would bring new capital 

to the banking industry. The writer 

questions whether the industry as a 

whole is undercapitalized. She sug 

gests that further consolidation within 

the industry should enable many in 

dividual banks in need of capital to 

meet their requirements. Also, the 

commercial firms most interested in 

banking probably would be more likely 

to expand their own bank-like opera 

tions rather than buy existing full-ser 

vice banks if permitted to do so. 

Also in favor of ownership of banks 

by commercial firms, but not support 

ed by the evidence, is the claim that 

the combination might lower the cost 

of providing services through scale or 

scope economies. Most studies, how 

ever, of scale economies in banking 

suggest that they are exhausted in 

banks of relatively small size (around 

$100 million of deposits), and if they 

occur at all in larger banks, are small. 

As to scope, in a recent empirical study, 

Ms. Mester found diseconomies be 

tween traditional commercial bank 

activities and certain potential synergyyielding, bank-nontraditional activities. 

There may be synergies through crossmarketing of bank products and 

commercial firm products that might 

yield enhanced revenues. While 

some of this does occur, the perfor 

mance of nonbank banks, which can 

provide both commercial and finan 

cial products, does not indicate that 

they have a significant advantage over 

commercial banks from revenue or 

cost synergies. 

Diversification of firms into finan 

cial services and commercial produc 

tion could lower their risks, if profits 

in the commercial activities could be 

used to offset losses from financial 

services. Based on limited studies of 

the correlation of the earnings of banks 

and nonbanking industries, there ap 

pears to be some potential for re 

ducing banks' risk through such 

diversification. 

The claim that allowing commer 

cial firms to own banks would cause 

the industry to become overconcen

trated is not supported by the evi 

dence. The results of scale and scope 

studies, and experience from nonbank 

banks suggesting that tie-ins would 

not be a problem, are cited. 

If commercial firms had access to 

bank deposits by affiliates' transac 

tions, regulators would have to tighten 

firewalls or closely monitor the risky 

activities of the holding company, at 

least until the new provisions of 

FDICIA take effect calling for riskbased assessments. If firewalls, how 

ever, are strengthened too much, 

potential synergies and benefits from 

diversification would be cancelled out. 

Regarding affiliates' riskiness spread 

ing to the bank, management studies 

suggest that the management of a par 

ent and its subsidiaries is usually cen 

tralized. In several cases banks have 

acted to prop up ailing affiliates even 

when under no legal obligation. 

The article concludes that in many 

cases the net benefits of commercial 

firms' ownership of banks depend on 

the ability of regulators to control pos 

sible abuses of the financial system by 

its participants. Without necessary 

changes to the current system, the 

potential costs of allowing banking 

and commerce to mix outweigh the 

potential benefits. However, as the 

56 
Recent Developments 

reforms contained in FDICIA, such as 

risk-based deposit insurance premiums 

and limits on too-big-to-fail, are im 

plemented, the prohibitions against 

commercial firms' owning banks and 

vice versa will need to be reconsid 

ered. Business Review, Federal Reserve Bank of 

Philadelphia, MaylJune 1992, pp. 11-29. 

"Transferable Puts"for 

Loans at Failed Banks 

This article by Eric S. Rosengren 

and Katerina Simons discusses a pro 

posal by Richard F. Syron, President 

of the Federal Reserve Bank of Bos 

ton, for a mechanism to help relieve 

current credit availability problems by 

making existing FDIC guarantees of 

loans transferable throughout the 

private financial system. 

One of the distinctive features of 

the current problems has been the 

rapid growth in "performing nonper

forming loans," which are loans current 

on payments of principal and interest 

whose collateral value has dropped 

below the value of the loan. Many of 

these loans are in the portfolios of 

failed banks whose assets are control 

led by the FDIC. When a bank fails, 

the FDIC normally tries to find a bank 

to buy the deposits and good assets of 

the failed banks, and normally allows 

the acquiring banks to return substan 

dard loans, including performing non

performing loans, to the FDIC for full 

face value during the first year after 

the acquisition. This "put" to the 

FDIC is at a discount to the full face 

value after the first year and normally 

does not exceed three years. Once 

assets have been put back to the FDIC, 

they are normally transferred into a 

"bad asset" pool. The FDIC usually 

contracts to have these assets man 

aged by collecting agencies, which are 

instructed to maximize the cash flow 

to the FDIC, after appropriately dis 

counting for the time value of money 

for cash received in the future. These 

management contracts provide neither 

the incentive nor the ability to work 

out loans in the way that might have 

been done, had the borrower had a 

relationship with a well-capitalized 

bank. As a result, too many loans arc 

foreclosed. 

Under Mr. Syron's proposal, when 

performing nonperforming loans are 

placed in the equivalent of "bad 

banks" by the FDIC, the borrower 

could transfer the loan to any willing 

financial institution, with the same 

government guarantee on the loan that 

is currently extended to acquirers of 

failed banks in effect, making the 

put transferable. The resulting com 

petition for "puttable" failed-bank 

assets would provide a market for per 

forming nonperforming loans that 

would reduce the number of liquida 

ted loans and potentially reduce costs 

to the FDIC. 

How extensively banks would lend 

to borrowers with transferable puts 

would depend, at least in part, on the 

regulatory treatment of these loans 

under the risk-based capital standards. 

If the puts were treated as govern 

ment securities, they would receive a 

risk-weighting of zero; however, if they 

were treated as agency securities they 

would receive a risk-weighting of 20 

percent. Given the shortage of capital 

at many New England institutions, a 

risk-weighting of 20 percent could dis 

courage some lenders. In addition, 

many institutions are shrinking and 

may not want to acquire loans that 

require substantial monitoring. None 

theless, for borrowers with transfer 

able puts able to find a willing lender, 

their risk of liquidation may be sig 

nificantly reduced. New England Economic 

Review, Federal ReserveBank ofBoston, MarchjApril 

1992, pp. 4-11. 

Would a Reconstruction 

Finance Corporation 

Work Today? 

Some would contend, writes Wil 

liam R. Keeton, that a program of gov 

ernment investment could avoid the 

unnecessary closure of weak, but vi 

able banks, thus benefitting the tax 

payer and the economy as a whole. 

The successes of the Reconstruction 

Finance Corporation (RFC) in the 

Great Depression are cited as evidence 

that this approach could also work to 

day. By purchasing preferred stock 

in thousands of banks, the RFC is 

claimed to have spurred a strong re 

covery in banking. This article 

reviews the current debate over gov 

ernment investment, examines the re 

cord of the RFC in the 1930s, and 

considers the implications of the RFC 

experience for the current debate in 

the light of key differences between 

the 1930s and today. 

Proponents of government invest 

ment argue that some weak banks 

should be left open because they are 

viable. Such banks may have valuable 

intangible assets, such as long-term 

relationships with depositors and bor 

rowers, that would be lost if the bank 

were closed, even if later it was resold 

to a healthier bank. Further, under 

"prompt corrective action," weak but 

viable banks would be forced to close 

because they would not be able to 

raise enough capital to meet the min 

imum requirements. In that connec 

tion, because regulators examine 

banks on a regular basis it is con 

tended that the government is usually 

in a better position than private inves 

tors to determine which troubled banks 

are truly viable. Critics of government 

investment in weak banks say it would 

lead to excessive ownership and con 

trol of the banking industry, and, con 

trary to the above argument, the 

government would in fact prop up 

many nonviable banks. 

In its program for purchasing the 

preferred stock (and subordinated 

debt) of undercapitalized banks, the 

RFC spent a total of $1.2 billion, peak 

ing in 1935 at $892 million of bank 

capital held, consisting of $869 mil 

lion in commercial banks and the rest 

in mutual savings banks. The invest 

ment in commercial banks accounted 

for 14 percent of the industry's total 

book capital and involved 5,685 banks 

40 percent of all insured banks. (In 

addition to this type of assistance, the 

RFC made direct loans to businesses, 

Financed emergency relief and public 

works projects, and helped fund 

mobilization for World War II.) 

Banks with high RFC capital failed 

at a higher rate than other banks, sug 

gesting that a greater fraction of RFC 

banks were nonviable or took exces 

sive risk than in the industry as a 

whole. However, the failure rate of 

57 
FDIC Banking Review 

RFC banks was not very high in num 

bers, further suggesting that the frac 

tion of nonviable banks or risk-prone 

banks was also not very high. Thus, 

while the RFC may have assisted some 

nonviable banks that later failed, it may 

have rescued an even greater number 

of viable banks that later recovered. If 

so, the preferred-stock program was a 

better way to deal with weak banks 

than prompt corrective action, though 

not necessarily superior to forbearance. 

The favorable record of the RFC 

suggests that government investment 

can sometimes work better than 

either prompt corrective action or 

forbearance. In particular, govern 

ment investment can help viable 

banks recover without nationalizing 

the banking industry, propping up 

large numbers of nonviable banks, or 

encouraging excessive risk-taking. 

However, the many differences be 

tween the 1930s and today also sug 

gest that government investment 

should be used with caution. Among 

other conditions, government invest 

ment should always be provided in a 

form that reduces banks' incentive to 

gamble by forcing them to give up a 

share of their future profits. Economic 

Review, Federal Reserve Bank of Kansas City, 1st 

Quarter 1992, pp. 33-54, 

58