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2003 VOLUME 15, NO. 1 

Catastrophe Securities and the Market Sharing of 

Deposit Insurance Risk 

by Kevin P. Sheehan (page 1)

The Federal Deposit Insurance Corporation (FDIC) and the property/casualty insurance industry 

have both faced a considerable increase in concentration risk over the past several decades.

Property/casualty insurance companies have attempted to address their increased exposure through

reinsurance, using either conventional reinsurers or innovative market instruments. The article

examines a number of issues the FDIC will face if it takes a similar approach to reducing its exposure 

to large-bank failure.

Risk Assessment: Results of an International 

Survey of Deposit Insurers 

by Jane F. Coburn and John P. O'Keefe (page 17)

The authors summarize and discuss results of a Federal Deposit Insurance Corporation survey of

foreign deposit insurance organizations. The article focuses on risk-assessment practices of these

deposit insurance organizations. 

Recent Developments Affecting Depository 

Institutions (page 36)

by Lynne Montgomery

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

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

issues.

The views expressed are those of the authors and do not necessarily reflect official positions of the Federal Deposit Insurance

Corporation. Articles may be reprinted or abstracted if the FDIC Banking Review and author(s) are credited. Please provide the

FDIC's Division of Insurance and Research with a copy of any publications containing reprinted material.

Single-copy subscriptions are available to the public free of charge. Requests for subscriptions, back issues or address changes

should be mailed to: FDIC Banking Review, Public Information Center, 801 17th Street, N.W., Washington, DC 20434.

Chairman Donald E. Powell

Director, Division of Insurance Arthur J. Murton

and Research

Deputy Director Fred Carns

Executive Editor George Hanc

Managing Editors Jack Reidhill

Lynn Shibut

Publication Manager Geri Bonebrake
FDIC Banking Review 

Catastrophe Securities and the Market 

Sharing of Deposit Insurance Risk 

by Kevin P. Sheehan*

Over the past two decades, the U.S. banking

industry has experienced an unprecedented wave

of consolidation. Today the 100 largest banking

organizations hold nearly three-quarters of all

industry assets. With the industry now dominated

by a small number of institutions, any banking crisis could involve the failure of one or more of

these large banks. Thus, although the history of

the Federal Deposit Insurance Corporation

(FDIC) is primarily a record of small-bank failures,

the consolidation of the industry suggests a future

of possible large-bank failures that might expose

the Corporation to unprecedented deposit insurance losses.

This outlook is comparable to the one projected

by recent trends in property/casualty insurance.

Catastrophic insurance losses from earthquakes,

hurricanes, and other natural disasters have

already reached unparalleled levels, and

property/casualty insurers are anticipating even

larger losses in the future.

* Kevin P. Sheehan is a senior economist in the Single Family Model Development and Portfolio Management Division of Freddie Mac. 

The comments and suggestions of James Marino and Lynn Shibut are gratefully acknowledged. Sarah Bohn, Melissa King, and Justin Combs provided 

excellent research assistance. The views expressed are those of the author 

and not necessarily those of the Federal Deposit Insurance Corporation or 

Freddie Mac. 

The disasters of hurricane Andrew and the Northridge earthquake alone cost the insurance industry

more than the cumulative insured losses from

catastrophes in the decade before those events.

Losses from the two disasters totaled over $45 billion in 1997 dollars, with insured losses running

about $30 billion. These insured losses compare

with cumulative insured losses from natural catastrophes in the previous decade of only about $25

billion.1 Yet, although the Atlantic and Gulf

coastal regions of Florida are exposed to hurricanes and much of California is vulnerable to

earthquakes, the population in these states has

grown at two or three times the national average

for the last three decades. Given this population

growth, scenarios constructed by catastrophe modelers now suggest the possibility of a $76 billion

hurricane in Florida, a $72 billion earthquake in

California, and even a $21 billion hurricane in the

Northeast. 2

Faced with this increased exposure and seeking an

alternative to traditional methods of managing

their risk load, property/casualty insurance compa1 See Froot (1997). 


2 See Cummins, Doherty, and Lo (2002). 


1 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

nies have turned to capital markets. The securities market appears to offer insurance companies

an avenue for diversifying their natural disaster

risk.

This type of diversification requires securitizing

property catastrophe risk. Such securities transfer

property catastrophe risk to investors. One example is a catastrophe bond that offers an insurance

company some degree of debt forgiveness in the

event of a hurricane or some other predefined natural disaster. Another innovative instrument is a

catastrophe equity put that allows an insurance

company to recapitalize after a catastrophe by

exercising a put option on its own stock. Other

insurance-based financial instruments include

exchange-traded property catastrophe options and

property catastrophe swaps. 

Property/casualty insurers have recently begun to

issue these catastrophe securities. Surprisingly,

property/casualty insurers use little reinsurance.

These insurers overwhelmingly retain, rather than

share, their large-event risks; and even with the

introduction of catastrophe securities, the amount

of risk sharing has not increased. The limited risk

sharing in private insurance markets can be partly

attributed to the presence of moral-hazard problems. Froot (1997) presents a number of other

explanations for the limited sharing of catastrophe

risk. These include behavioral explanations, market power on the part of reinsurers, and price regulation at the state level. Like property/casualty

insurers, the FDIC is exposed to large-event risk:

a large-bank failure does not happen often, but

such an event could result in huge deposit insurance losses. If the FDIC attempted to shift its

risk, the Corporation might find itself limited by

many of the same factors. 

This article investigates issues that property/casualty insurance companies are facing and that the

FDIC should consider if it, too, decides to address

its increased exposure by securitizing the risk it

faces-in the case of the FDIC, the risk of largebank failure. Specifically, the article details how

the insurance companies and the FDIC might

reduce their exposure either by entering the reinsurance market directly or by issuing their own

catastrophe securities. The article concludes that

both kinds of risk shifting are likely to be limited

by a number of factors. The one this article focuses on is the moral-hazard problem, because such a

focus leads to a number of interesting implications

for the market sharing of deposit insurance risk.

Property Catastrophe Risk and Conventional 

Reinsurance 

Figure 1 illustrates that losses are highly predictable for some large pools of insurance risk. For

a noncatastrophic event such as fire loss, an insurance company diversifies its risk by creating a

large portfolio of independent risks so that (by the

law of large numbers) the average loss approaches

the mean of the loss distribution (that is, the

expected value of losses). Risk-averse individuals

are willing to pay something for fire insurance, and

one can show that this amount is greater than the

expected value of losses.3 Given the willingness

to pay this amount, an insurer holding a large

portfolio of fire insurance policies can provide coverage by simply charging policyholders a premium

approximately equal to its average loss (per dollar

of insurance). 

Figure 2 illustrates that property/casualty insurers

cannot effectively reduce the variance of cost from

natural disasters by creating large pools. Unlike

other lines of insurance, losses from earthquakes,

hurricanes, and other natural disasters are highly

3 To see this, consider a risk-averse individual whose wealth, W, is subject to 

a random loss, L. Risk aversion can be represented by a concave utility 

function, U(). Given the concavity of U(), one can show that 

EU (W – L) < U (W – L), where E is an expectation operator and L 

is the expected value of losses. This result lends itself to the interpretation 

that follows. First note that the expression EU (W – L) defines the 

expected utility of random wealth while the expression U (W – L) defines 

the utility for a specific amount of certain wealth. Certain wealth can be 

obtained by purchasing complete insurance, and the amount of this wealth 

equals the initial wealth less an insurance payment. Now, if a risk-averse 

individual acquires complete insurance by paying a premium equal to the 

expected value of losses, the utility from insured (i.e., certain) wealth, 

U (W – L), is greater than the expected utility from uninsured (i.e., random) wealth, EU (W – L). Such an individual is therefore better off purchasing insurance, and this would be true even if the premium were slightly 

larger than L. 

2003, VOLUME 15, NO. 1 2 
FDIC Banking Review 

Figure 1 

1950 1960 1970 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 

0 

5 

10 

15 

20 

25 

30 

$ Billions (1995 dollars) 

Source: Lewis and Murdock (1996).

U.S. Fire Losses,1950–1994 

Figure 2 

1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 

0 

5 

10 

15 

20 

25 

30 

$ Billions (1995 dollars) 

Source: Lewis and Murdock (1996).

Insured Disaster Losses, 1949–1995 

3 2003, VOLUME 15, NO. 1 
 

 

 

 

FDIC Banking Review 

correlated. When a hurricane hits the coast of

Florida, for example, most homes in the region

incur some damage. Insurance companies typically reduce the variance of their cost by pooling risk

across policyholders, but given the highly correlated nature of natural disaster risk, property/casualty

insurers cannot fully diversify by using traditional

insurance methods. 

In the case of independent risk (such as fire loss),

an insurer can plan to pay losses out of premium

income.4 Because costs are relatively certain, an

insurance company provides coverage by charging

a premium approximately equal to its average loss

(per dollar of insurance). For catastrophe risk, in

contrast, the annual pattern of losses is highly

variable, and large amounts of capital are required

to cover potentially huge losses. In this case, an

insurer provides coverage by holding enough capital to cover potentially huge insurance losses.5

This capital finances the purchase of liquid securities, and in the case of a natural catastrophe, the

insurance company liquidates these securities to

pay policy claims.

Reinsurance allows an insurer to provide catastrophe coverage while holding only a limited amount

of capital. When broadly used, reinsurance can be

interpreted as a pooling arrangement that mutualizes the industry's risk. Under this risk-sharing

arrangement, individual insurance companies hold

only limited amounts of capital, and each insurer

is accountable for a proportion of total industry

4 Even so, an insurance fund is necessary to cover unexpected losses. However, little capital is needed when insurance losses are relatively constant 

through time. 

5 In theory this capital should be readily available. Modern portfolio theory 

tells us that a security should be priced in terms of its correlation with the 

market portfolio. The return on Treasury securities is not correlated with the 

returns on stocks and bonds. Given that catastrophe exposures are not correlated with the returns on a market portfolio, an insurance company could 

attract capital by promising to pay an expected return equal to the return on 

Treasury securities. To generate this required return, holders of these zerobeta assets would receive the interest earnings from the insurer’s portfolio of 

liquid securities as well as additional compensation for expected insurance 

losses. The insurance company would fund this risk premium by charging 

policyholders an amount equal to the expected value of the losses. However, 

since risk-averse individuals are willing to pay amounts greater than the 

expected value of losses, the insurer could fund an even larger premium and 

offer investors excess returns for the use of this risk-taking capital. Of 

course, capital constraints may exist, and possible sources of this market friction are identified below. 

losses. That is, each insurer pays a proportion of

total losses, and the pooling of industry resources

through reinsurance contracts ensures that adequate capital is in place to provide this catastrophe coverage. 

Thus a major objective of reinsurance is to share

or distribute the risk of loss.6 The primary insurance market is characterized by the sale of insurance policies from a primary insurer to the

insured, and primary insurers may then cede or

pass on some or all of their insurance risk to a

reinsurer. Through reinsurance transactions, primary (or direct) insurers share the risk of loss with

reinsurers (and/or other primary insurers). In

return for a premium payment, an insurer transfers

some of its loss exposure to a reinsurer, and the

reinsurer agrees to indemnify the insurer for losses

falling within the reinsurance agreement.

Reinsurance contracts take the form of either facultative agreements or treaties. With facultative

reinsurance, the primary insurer negotiates a separate contract for each policy that it reinsures.

Treaties are agreements whereby the reinsurer

agrees to accept all policies of a particular typeproperty/casualty policies, for example. In both

cases, reinsurers charge a premium for assuming

this risk. In addition, this reinsurance can be

broadly categorized as either pro rata coverage or

excess-of-loss protection. A pro rata policy provides the primary insurer with coverage against a

fixed percentage of losses, whereas an excess-ofloss policy provides protection for a fixed amount

of losses above a specified threshold, or attachment point.

As mentioned above, however, primary

property/casualty insurers use reinsurance to cover

only a relatively small amount of their catastrophic exposures.7 Swiss Re (1997) reports that only a

fraction of the exposure in United States' hazard6 Geographical diversification is another important objective of reinsurance. 

See Cummins and Weiss (2000) for a general discussion of reinsurance. 

7 This article argues that such limited coverage can be explained to some 

degree by the presence of moral-hazard and adverse-selection problems. 

Again, see Froot (1997) for additional explanations for the limited use of 

catastrophe reinsurance coverage. 

2003, VOLUME 15, NO. 1 4 
 

FDIC Banking Review 

prone states is covered by catastrophe reinsurance.

In fact, an analysis by Froot of a large sample of

reinsurance contracts finds that "reinsurance coverage as a fraction of exposure is high at first (after

some small retention) and declines markedly with

the size of the event, falling to a level of less than

30 percent for events of only $8 billion."8

The reason property/casualty insurers use relatively little reinsurance is that it is available only in

limited quantities and at very high prices. Limited

quantities are evidenced by the fact that reinsurance coverage typically involves deductibles and

insurance limits. The high cost of reinsurance is

illustrated by a reinsurance transaction involving

the California Earthquake Authority (CEA). In

late 1996 CEA purchased reinsurance from

National Indemnity, a subsidiary of Berkshire

Hathaway. According to Froot, "[u]nder the

structure of the reinsurance contract with National Indemnity the actuarially expected loss was 1.7

percent and the [insurance] limit was $1.05 billion. In return for bearing the earthquake risk

National Indemnity received an annual premium

of $113 million-or 6.3 times the actuarially

expected losses of $18 million."9

Industry-wide prices on reinsurance contracts

seem to match almost exactly the pricing of the

CEA contract. However, further analysis shows

that much of the high premium-to-expected-loss

ratio (which is averaged across all layers) comes

from coverage for the highest layers of lossesthat is, coverage for low-frequency, high-severity

events. Around the time of the CEA transaction,

reinsurance coverage for these low-frequency,

high-severity events required premiums greater

than 25 times expected losses, as Figure 3 indicates. The figure shows the premium-to-expected-loss ratios (by year) for different layers of

reinsurance coverage. The axis labeled "exceedence decile" identifies the likelihood (from high to

low) that insurance losses will exceed the

deductible on a reinsurance contract. On this

axis, a value of 10 corresponds to the small proba8 Froot (1999), 12. 

9 Ibid., 6. 

bility that insurance losses will exceed a very large

deductible. Since reinsurance coverage for the

highest layers of losses involves contracts with

very large deductibles, the back row of the figure

identifies the spread over expected losses for catastrophic coverage. 

The evidence of high prices provided by Figure 3

is consistent with a limited demand for reinsurance services. High prices are inferred from the

observation that insurance premiums are significantly greater than expected losses. Such large

spreads can explain the limited demand for reinsurance; however, expected losses may be underestimated because we are dealing with extremely

rare events. If expected losses are underestimated,

the actual spreads are somewhat smaller than

those appearing in the figure. Nevertheless, even

if one were to revise expected losses substantially

upward, the magnitude of the spreads would

remain large, and the revised spreads would still

indicate the high cost of reinsurance coverage.

Reinsurance markets are subject to price and

availability cycles, which often result in price

increases and supply restrictions following catastrophic events. "The market alternates between

'soft markets,' when coverage is [somewhat] plentiful and prices are relatively low, and 'hard markets,' when availability of coverage is limited and

prices are relatively high."10 The CEA transaction occurred just after hurricane Andrew and the

Northridge earthquake, so temporary supply

restrictions might have significantly affected

prices.

More generally, however, high prices can be

explained by a couple of different factors. First,

the high cost of coverage for the upper layers of

natural disaster risk can be explained to some

extent by the size of the losses as well as the difficulty of estimating such losses. In addition, the

high cost of reinsurance coverage for low-frequency, high-severity events can be partly explained by

10 Cummins and Weiss (2000), 181. 

5 2003, VOLUME 15, NO. 1 
5

FDIC Banking Review 

Figure 3 

1994 1993 1992 1991 1990 1989 1988 1987 

1986 

1985 

1984 

1983 

1982 

1981 

1980 1 2 3 4 5 6 7 8 9 10 

Exceedence decile 

(1=highest probability) 

Premium 

to 

Expected 

Loss 

30 

25 

20 

15 

10 

Source: Froot (1997). 0

Premium to Expected Loss, by Exceedence Probability and Year 

the presence of severe ex post moral-hazard problems. As Doherty explains,

Ex post moral-hazard problems arise when the

loss-settlement practices of the insurer are

relaxed because of the presence of reinsurance.

This is a particular problem for catastrophe

losses. The loss-settlement capacity of any

insurer-and the industry as a whole-is

geared to its normal loss frequency. When an

event such as hurricane Andrew arises, primary

firms simply do not have the capacity to

inspect and negotiate claim settlements thoroughly. Thus, it becomes more difficult to prevent the "build up" of claims (from

policyholders' tendency to include uninsured

damage in the claim or exaggerate the size of

the losses) or outright fraud on the part of policyholders. However, the incentive for the primary insurer to control its claims will be

relaxed if it has reinsurance protection.11

11 Doherty (1997), 87. 

For catastrophe losses, concern exists that the primary insurer might pass on the costs of excess settlements to its reinsurer. "For moderate losses, the

primary firm may well consider its reputation in

the reinsurance market before engaging in such

opportunism. . . . [But when] insurers are facing

financial stress [from catastrophe losses], maintaining their reputation in reinsurance markets is

likely to become a secondary concern."12 Thus,

ex post moral-hazard problems are likely to be

restricted to coverage for catastrophic events, and

the presence of such distortions may partly explain

the existence of large premiums for the highest

layers of reinsurance coverage.13

12 Ibid. 

13 Catastrophe reinsurance contracts are typically issued with insurance limits 

that preclude coverage for the very highest layers of losses. A possible explanation for this lack of coverage is that ex post moral-hazard problems are 

most severe for the very highest layers of losses. According to this explanation, insurance limits are in place because the presence of such severe moralhazard problems precludes the provision of reinsurance coverage. 

2003, VOLUME 15, NO. 1 6 
 

FDIC Banking Review 

Securitization of Property Catastrophe Risk 

Property/casualty insurers overwhelmingly retain,

rather than share, their large event risks-in other

words, these insurers provide coverage by holding

their own capital. But because the U.S. commercial property/casualty insurance industry has only

a limited amount of capital, a major California

earthquake or Florida hurricane would stress the

capacity of this industry.14 More capital is needed, but raising additional equity capital would not

be an efficient solution to this problem of capital

adequacy. Jaffee and Russell (1997) point out that

holding capital in an insurer is costly because of

the regulatory and agency costs of operating an

insurance company, as well as accounting and tax

rules that penalize the accumulation of equity capital. 

Although a $100 billion catastrophe might wipe

out the capital of the property/casualty insurance

industry, a loss of that magnitude is less than onehalf of 1 percent of the value of stocks and bonds

traded in U.S. securities markets. Securities markets have the capacity to absorb huge losses, and

insurers have recently sought to address their

increased exposure and the problem of capital

adequacy by introducing reinsurance-like contracts that would facilitate the sharing of catastrophe risk more broadly across these markets. This

securitization of insurance risk is potentially a

more efficient approach to financing catastrophic

losses than conventional insurance and reinsurance. Cummins and Weiss point out that "[s]ecurities markets are more efficient than insurance

markets in reducing information asymmetries and

facilitating price discoveries, potentially smoothing

or eliminating insurance price cycles. Moreover,

insurance-linked securities cover zero-beta events

and thus are valuable to investors for diversification purposes."15

As noted earlier, despite these advantages, catastrophe securities have done little to expand reinsurance capacity. Reinsurance capacity is limited

by the presence of moral-hazard and other transaction costs. Reducing these transaction costs

would expand reinsurance capacity; however, it

appears that these new securities have failed to

reduce costs. As shown below, catastrophe

options greatly reduce moral-hazard problems but

only by introducing basis risk. On the other hand,

catastrophe bonds do not reduce costs because

they fail to adequately address moral hazard.

Without effectively solving moral-hazard problems, these securities are nothing more than synthetic reinsurance that is plagued by the same

incentive conflicts as conventional reinsurance. 

Catastrophe Options

The similarity between an excess-of-loss reinsurance contract and a call spread (defined below)

allows for an easy transformation of insurance risk

into exchange-traded options. Catastrophe

options can be found on the Bermuda Commodities Exchange, and until recently, catastrophe

option contracts were also traded on the Chicago

Board of Trade (CBOT). Catastrophe option contracts are based on various industry indices of

property liability losses. For example, a contract

on the CBOT was based either on a national

index, a regional index (Western, Midwestern,

Southeastern, Northeastern, and Eastern), or a

state index (California, Florida, and Texas).

A typical excess-of-loss reinsurance contract provides an insurer with protection above an agreedupon dollar amount of insurance losses. For

example, a 10/30 excess-loss layer provides indemnification for the first $10 million (limit) in insurance losses over $30 million (the attachment

point). This excess-of-loss policy is similar to the

insurer hedging its risk by buying a catastrophe

option at a strike price of $30 million and simultaneously selling a catastrophe option with a strike

price of $40 million.16 This combination of being

16 On the CBOT, the level of industry-wide losses was converted to an index, 14 Greenberg (2001) reports that just before the September 11, 2001, terrorist and the catastrophe option contracts were written in terms of the index. attacks, the U.S. commercial property/casualty insurance industry had Since an index point represented $10 million insurance losses, the long posi­ between $100 billion and $125 billion in aggregate capital. tion described above, for example, was an option with a strike price of 3 15 Cummins and Weiss (2000), 207. index points. 

7 2003, VOLUME 15, NO. 1 
 

FDIC Banking Review 

long (that is, buying a catastrophe option) at one

strike price and at the same time short (that is,

selling a catastrophe option) at a higher strike

price is known as a call spread.

When insurance losses have exceeded the strike

price, the buyer of a catastrophe option receives

(or the seller of the option pays) the difference

between the industry-wide insurance losses and

the striking price. Thus a long position with a

strike price of $30 million enables an insurer to

receive payment for the excess loss over $30 million, whereas a short position with the strike price

of $40 million places a cap on this payment of $10

million. With industry-wide insurance losses of

$100 million, for example, the payment is capped

at $10 million because a $70 million gain on the

long position is offset by a $60 million loss on the

short position.17

Moral hazard arises whenever an insured party, by

virtue of being insured, fails to take precautions to

prevent the event being insured against. Reinsurance protection can relax the normal incentives

for the primary insurer to underwrite carefully and

settle claims efficiently. As Doherty explains, 

[T]he primary may [become] lax in its underwriting procedures, pay inadequate attention to

its own spread of risk, and fail to provide adequate risk audits for potential new policies. . . .

[Moreover the] primary may be able to avoid

the abnormal transaction costs of settling

claims, and even buy some goodwill with its

policyholders by making generous settlements

with policyholders and passing on the costs of

excess settlements to its re-insurer.18

Catastrophe options seek to control this moral

hazard by using industry (or sub-industry) indices.

The basic idea is to define the contract payoff in

relation to some variable that is correlated with

insurer losses but over which the insurer has little

17 A call option provides the holder with the right to buy an underlying asset 

at a fixed price, called the strike price. The holder exercises a call option 

only if the value of the underlying asset is greater than the strike price. A 

catastrophe option is a call option in which insurance losses determine the 

value of the underlying asset. In the example above, the holder exercises the 

option because the level of industry-wide insurance losses sets the value of 

the underlying asset to an amount that is greater than the strike price. 

18 Doherty (1997), 87. 

or no control. Then when using catastrophe

options, a primary insurer that is able to practice

cost mitigation will receive much of the benefit of

that activity in the form of reduced claims. 

To illustrate, suppose an insurer has a portfolio

that represents 5 percent of the market covered by

an index. This insurer can obtain upper-layer coverage by purchasing a catastrophe option that pays

0.05 times the payoff on the amount by which

industry losses exceed a strike price. Loss-control

efforts by the insurer may lower industry losses

and therefore reduce its option payoff. But, since

the insurer is hedging only 5 percent of the index,

every $100 reduction in direct claims reduces the

option payoff for the insurer by only $5. In other

words, the insurer receives a net benefit from any

cost mitigation equal to 95 percent of the reduction in its direct claims. 

Niehaus points out that, "various methods are

used to mitigate [moral-hazard] problems, including costly monitoring (both ex ante and ex post)

and incomplete risk sharing of catastrophe risk

(i.e., deductibles, coinsurance, and [insurance]

limits)."19 Catastrophe options have attempted to

facilitate a more complete shifting of risk by moving away from deductibles and coinsurance.

These securities control incentive conflicts by

tying the payoff to an index that, for the most

part, cannot be influenced by the actions of market participants. Indexing greatly reduces or eliminates moral hazard, but this approach has failed

to significantly increase risk sharing because it has

been found to expose insurers to unacceptable levels of basis risk. 

Insurers use reinsurance to hedge their underwriting risk. A conventional reinsurance contract

provides an insurer with a perfect hedge; that is,

the reinsurance payment exactly offsets insurance

losses. The option payoff is based on aggregate

claim payments, but since industry and firm losses

are not perfectly correlated, the payoff will not

necessarily offset the insurance losses suffered by

the primary insurer. In fact, if little correlation

19 Niehaus (2002), 590. 

2003, VOLUME 15, NO. 1 8 
 

 

 

 

FDIC Banking Review 

exists between industry and firm losses, then it

would be highly probable that an insurer would

suffer large underwriting losses while at the same

time receiving a zero payment on its option position. This hedging risk is referred to as basis risk,

and as Harrington and Niehaus point out, "[catastrophe options] can have considerable basis risk,

i.e., the losses on a particular insurer's book of

business may not be highly correlated with the

indices underlying the contracts so that little

underwriting risk can be eliminated."20

Ideally, insurers would bear some amount of hedging risk in exchange for reducing moral hazard.

However, the significance of basis risk can be

observed from contract design. Conventional

reinsurance has no basis risk since the payoff is

based on insurer-specific (or hedger-specific) losses. Conventional reinsurance contracts can

always be structured so that the payoff is triggered

by industry losses rather than the insurance firm's

own losses. "But the fact that reinsurance contracts traditionally have not been designed in this

way suggests that basis risk is an important consideration."21 In fact, "the perception among insurers that index securities are subject to

unacceptable levels of basis risk has been identified [by the American Academy of Actuaries

(1999)] as the primary obstacle to the more rapid

development of the market."22

Today, trading in catastrophe options is limited to

the Bermuda Commodities Exchange. In 1992

the CBOT launched an option contract based on

the U.S. Property Claims Service (PCS) Index, but

the volume of PCS index option contracts peaked

at only 15,706 contracts in 1997 and declined to

561 contracts in 1999. The CBOT has since

delisted these options because of a lack of interest. 

20 Harrington and Niehaus (1999), 50.
 

21 Doherty (1997), 87.
 

22 Cummins, Lalonde, and Phillips (2000), 2. However, a few studies have
 

concluded that the basis risk associated with derivative contracts based on
 

state-specific indices is not large. See, for example, Harrington and Niehaus
 

(1999) and Cummins, Lalonde, and Phillips (2000). 


In addition to basis risk, the lack of interest might

also be attributed to credit risk. A seller of a call

spread is required to deposit liquid securities with

the option exchange, but the size of the deposit

amounts to only a fraction of the largest possible

loss. With less than full collateralization, the

buyer of a call spread faces credit risk similar to

that involved in purchasing reinsurance. Conventional reinsurance involves the risk that the reinsurer will be unable to pay its obligations to the

primary insurer. With a call spread, the insurer

has a claim only on the counterparty, so these

transactions expose the insurer to credit risk associated with potential counterparty default.

Exchanges typically address counterparty credit

risk by guaranteeing contract performance, but

huge potential losses raise questions about an

exchanges' ability to ensure the performance of

any significant volume of contracts linked to property liability losses. 

Catastrophe Bonds

Like catastrophe options, the market for catastrophe bonds has been rather slow in developing.

Cummins, Lalonde, and Phillips (2000) report

that markets have accommodated only about 20

catastrophe-bond issues, totaling around $3 billion

of insurance coverage. High cost explains the limited interest in these securities, and, as illustrated

below, high prices can be attributed to the failure

of the securities to adequately address moral hazard. 

United Services Automobile Association (USAA),

the fourth largest U.S. homeowner insurer, issued

one of the first catastrophe bonds in mid-1997,

selling $477 million of one-year bonds tied to hurricane losses.23 Buyers of these catastrophe bonds

could generally expect to receive full payment;

however, in the event of a hurricane, bondholders

23 The bonds were actually sold by a special purpose reinsurer called Residential Re. For tax and regulatory purposes, this company had to be run independently of USAA. USAA paid Residential Re a monthly premium, and 

Residential Re used this payment plus the earnings on a portfolio of liquid 

securities to pay interest to bondholders. If USAA were to incur insurance 

losses greater than $1 billion, Residential Re would provide insurance coverage by liquidating its portfolio. 

9 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

could forfeit interest and/or principal if USAA's

insurance losses were greater than $1 billion.24 By

purchasing a security with event-linked payments,

bondholders provided catastrophe excess-of-loss

coverage for 80 percent of the $500 million risk

layer between $1 billion and $1.5 billion of insured

losses suffered by USAA during a one-year period

in certain U.S. coastal states. That is, coverage

would pay for insurance losses in excess of $1 billion, with the maximum payment capped at $400

million.

The generic design of these instruments can allow

for interest and/or principal forgiveness, and the

extent of the forgiveness can be total, partial, or

scaled to the size of the loss. In the case of

USAA, a portion of the bond issue was principal

protected. Of the $477 million that USAA raised

from the sale of notes, the company used $77 million to purchase ten-year U.S. Treasury strips with

a maturity value equal to the $164 million of principal-protected notes. If an event resulted in

USAA losses exceeding $1.5 billion, $400 million

of debt would be forgiven, while the principal-protected notes would be repaid (with no interest) in

ten years from the proceeds of the Treasury securities. 

Debt-forgiveness instruments like catastrophe

bonds avoid the credit risk that is common to

reinsurance transactions-that is, the risk that the

reinsurer will be unable to pay its obligations.

Bondholders provide a hedge to the insurer by forgiving existing debt. Thus, the value of the hedge

is independent of bondholder wealth, and the issuing primary insurer faces no risk of nondelivery of

the hedge. 

A catastrophe bond can be forgiven on the basis

of either the primary insurer's own catastrophe

24 Notice the similarity between catastrophe bonds and the historical marine 

insurance described by Jaffee and Russell (1997, p. 207): “[A] market for 

marine insurance operated among ancient Greeks and Phoenicians and flourished in London from as early as the seventeenth century. [The insurance 

took the form of a loan that offered the ship owner some degree of debt forgiveness.] In . . . the so-called contract of bottomry, a lender advanced the 

ship-owning merchant the full cost of the voyage as a loan. If the voyage 

was successful, the ship owner repaid the bank at an interest rate which 

included a premium to reflect the risk of loss. If the ship was lost, the loan 

was forgiven.” 

losses or some industry index of catastrophe losses.

Moral hazard is limited when debt forgiveness is

triggered by an industry index of catastrophe losses. In the case of USAA, however, the company's

book was concentrated at military establishments,

so the basis risk from a debt issue with forgiveness

tied to an industry index was large. Since little

correlation existed between industry and firm losses, debt-forgiveness triggered by a level of industry

losses would not necessarily offset catastrophe

losses suffered by USAA. For this reason, USAA

chose to issue bonds with debt forgiveness triggered by the level of the company's own insurance

losses. 

USAA's failure to use an industry index to address

moral hazard may partly explain the high cost of

issue for the company. Catastrophe exposures are

not correlated with the returns on stocks and

bonds.25 Under the assumptions of the capital

asset pricing model, the required rate of return on

a zero-beta asset is the risk-free rate of return.

Theoretically the interest rate on USAA bonds

would be the risk-free rate plus a premium large

enough to offset the expected loss of principal

and/or interest due to a catastrophic event.

USAA paid bondholders 451 basis points above

the London interbank offer rate (LIBOR) for principal and interest forgiveness. For the principalprotected notes, USAA paid bondholders 125

basis points over LIBOR.26 Although the estimated probability of a loss exceeding the trigger was

only 1 percent, interest rates included a premium

for principal and interest forgiveness of over seven

times the expected loss and about twice the

expected loss for only interest forgiveness.

Moral-hazard problems appear to explain the existence of such large premiums. Cummins, Lalonde,

and Phillips (2000) reports that Goldman Sachs �

Company estimated a median risk-premium to

expected-loss ratio of 6.8 for all catastrophe bonds

25 See Froot et al. (1995) for a discussion of the lack of correlation between 

catastrophic risk and traditional asset classes. 

26 USAA paid a total premium of 576 basis points for this layer of coverage. 

The premium for essentially identical coverage fell to 412 basis points in 

1998 and to 366 basis points in 1999. These bonds provided no principal 

protection and the reduction in costs can be attributed to lower estimates of 

expected losses. 

2003, VOLUME 15, NO. 1 10 
 

FDIC Banking Review 

issued through March 2000. Employing a sampling of Florida call spread transactions, the

authors in this paper estimated a median risk-premium to expected-loss ratio on Florida calls of 2.1.

Like catastrophe bonds, the risk premium on call

spreads might be attributed to illiquidity, uncertainty about expected loss estimates, and/or

investor unfamiliarity with the contracts. However, such factors should be somewhat similar across

both securities. But since only catastrophe

options resolve incentive conflicts by employing

industry (or sub-industry) indices, the higher premium on catastrophe bonds is likely attributable

to the failure of these securities to address moral

hazard by indexing. 

Catastrophe Swaps and Catastrophe

Equity Puts 

A catastrophe swap enables insurers to diversify

their risk by trading blocks of insurance policies.

"Each swap [is] a bilateral agreement, creating

reciprocal reinsurance between two insuring entities. . . . Property catastrophe risk varies by location, and [with a swap] participants [are] able to

[trade different] types of risk (for example, hurricane risk on the North Carolina coast for tornado

risk in Kansas)."27 Since August of 1997, property catastrophe swaps have been trading on the

Catastrophe Risk Exchange (CATEX). Over

1,400 listings have appeared on CATEX, and the

500-plus completed transactions involved nearly

$3 billion of insured coverage. However, only a

portion of these transactions involved property

catastrophe risk.

A catastrophe equity put (CEPut) is a post-loss

financing arrangement in which the price of the

equity issue is fixed. More specifically, a CEPut is

an option contract that gives the insurer the right

to sell a given number of shares to a specific counterparty for a fixed price, and this option can be

exercised only after the occurrence of a catastrophe of an agreed-upon magnitude (whereas the

typical option can be exercised at any time during

27 Borden and Sarkar (1996), 5. 

the contract period). To minimize potential moral

hazard, the trigger is most often defined in terms

of a level of industry-wide losses. However, defining the trigger in this way introduces basis risk.

The contract also exposes the insurer to the credit

risk associated with potential counterparty default,

but, again, some degree of credit risk is present in

all reinsurance transactions. 

Reinsurance or Securitization for Deposit 

Insurance Risk? 

As pointed out above, catastrophic insurance losses from earthquakes, hurricanes, and other natural

disasters are highly correlated, with a hurricane

(for example) causing damage to many homes in a

particular region. Similarly, the failure of a financial institution may cause all depositors across a

bank to suffer losses. Furthermore, because of

population growth in exposed areas such as Florida, property/casualty losses are increasingly more

correlated: one can expect more homes to be

damaged when a hurricane hits the coast. For the

FDIC, too, deposit insurance losses are more correlated today: because of bank consolidation, a

bank failure is likely to be associated with much

larger deposit insurance losses.28 Thus, for property/casualty insurers and the FDIC alike, insuring

against risk from highly correlated losses requires

either reinsurance or having access to a larger pool

of liquid capital to cover the larger insurance losses. 

Ideally, the FDIC would obtain reinsurance coverage for its exposure to large-bank failure. The

Federal Deposit Insurance Corporation Improvement Act authorized the FDIC to transfer up to

10 percent of its risk exposure to market participants, and in fact the Corporation is currently

exploring a limited reinsurance program.

Although reinsurance might allow the Corporation to reduce its exposure, deposit reinsurance

would also involve moral-hazard and other prob28 Even though potential insurance losses have increased, consolidation may 

be responsible for a decline in the likelihood of losses. That is, consolidated 

banks hold portfolios that are more diversified, so the probability of bank failure may be lower. 

11 2003, VOLUME 15, NO. 1 
 

FDIC Banking Review 

lems. The presence of these distortions suggests

that, unless the factors producing them are

accounted for appropriately, deposit reinsurance

coverage would probably be available only in limited quantities and at high prices. Indeed, the

cost of coverage for this large-event risk would

probably mirror the pricing for catastrophe reinsurance coverage for the highest layers of risk. A

recent survey of reinsurers estimated initial

deposit reinsurance capacity at about $2 billion;

the survey also found that reinsurers would expect

to receive a premium as high as 4 percent for a

layer of coverage with an annual expected loss of

only 1 percent.29

Like reinsurance coverage for the upper layers of

natural disaster risk, deposit reinsurance coverage

for large banks would be characterized by the

problems of size and parameter uncertainty. In

addition, deposit reinsurance would probably

include a premium that accounted for the presence of significant regulatory risk, including the

risk of ex post moral-hazard problems. These

problems arise because the reinsurer's losses could

be materially affected by the FDIC's actions in

regulating bank activities, resolving failed institutions, liquidating assets of failed institutions, and

accounting for such activities. 

Moving to an event-oriented contract might mitigate concerns about regulatory risk. Such a contract would call for a specified payment if a bank

failed, rather than an amount contingent on the

ultimate resolution and liquidation costs. While a

contract of this type would reduce risks associated

with FDIC actions related to asset sales or

receivership accounting policies, it would not

address regulatory risks associated with the regulation of troubled banks. Thus the challenge facing

the FDIC would be to identify a contract design

that minimized these and similar moral-hazard

problems.

Even with such a contract, deposit reinsurance

coverage would probably be subject to price and

availability cycles. After the failure of a large

29 See Marsh & McLennan Companies (2001), 5 and 21. 

bank, renewing reinsurance coverage would probably require the FDIC to pay premiums significantly greater than expected losses. (Of course, in

the opposite phase of the market cycle, the FDIC

might enjoy premiums that were lower than actuarial pricing would dictate.) And even in the

absence of a large-bank failure, renewing reinsurance coverage would probably be difficult during

down economic times.

Proponents of deposit reinsurance argue that reinsurance premiums could provide the FDIC with

valuable pricing information. That is, the FDIC

would acquire reinsurance coverage for individual

banks (or groups of banks) and then use reinsurance prices to price its own risk more effectively.

However, reliable pricing signals might be limited

by the presence of moral-hazard and other transaction costs. Deposit reinsurance would probably

involve a premium reflecting the presence of these

transaction costs. As shown above, such a phenomenon exists in the pricing of catastrophe securities. Recall that the premium was found to be

significantly higher on catastrophe bonds than on

catastrophe options. "The most likely explanation

for the difference between the premium-toexpected-loss ratios of CBOT options and catastrophe (CAT) bonds is investor concern about

moral hazard-CAT bonds, most of which settle

on losses of specific insurers, are potentially subject to significant moral hazard whereas moral

hazard is a relatively minor concern for CBOT

options."30 If such premiums could not be disentangled from the observed prices, the cost of

deposit reinsurance would provide misleading

information about the underlying price of deposit

insurance.

As pointed out above, property/casualty insurers

are turning not to reinsurance to manage the

problem of increased exposure, but to securitization-catastrophe bonds, catastrophe options, and

so forth. The FDIC, too, might gain access to the

pool of liquid capital it would need by similarly

securitizing its deposit insurance risk.

30 Cummins, Lalonde, and Phillips (2000), 32. 

2003, VOLUME 15, NO. 1 12 
 

FDIC Banking Review 

The FDIC could securitize its insurance risk by

issuing its own catastrophe securities. More

specifically, the Corporation could issue bonds (or

options) with payments linked to deposit insurance losses at large banks.31 The catastrophe in

this case would be the failure of a large bank, and

by issuing these catastrophe bonds, the FDIC

would cede a portion of its risk to investors. In

this way, the FDIC would take a less-prominent

role in insuring large-bank deposits, since private

markets would now absorb a larger amount of the

risk of bank failure.

However, just as property/casualty securitization of

risk is limited by the presence of moral-hazard and

other transaction costs, securitized deposit insurance risk would probably face similar distortions.

Thus, to evoke interest in its catastrophe securities, the FDIC would have to be more successful

than property/casualty insurers in addressing moral

hazard.

Moreover, the cost of such synthetic reinsurance

coverage might be prohibitive. For the few property/casualty insurers that found a market for their

catastrophe securities, investors required premiums that were significantly greater than expected

losses. The FDIC could expect to pay even higher

premiums. Bank failure is not completely independent of movements in the market, so catastrophe securities issued by the FDIC would not be

valuable to investors for diversification purposes.

It is this inability to provide the same diversification benefits as property catastrophe securities

that would probably make the premium higher for

securitized deposit insurance risk than for securitized property catastrophe risk. 

31 The FDIC could issue catastrophe bonds on individual banks, but such securities would introduce problems of adverse selection. Adverse selection arises 

when one side of a transaction has more reliable information than the other 

side. Disclosure is a common solution to this problem, and in an insurance 

market for catastrophic bank losses, the disclosure of information would 

address any such problems. However, it is highly unlikely that the FDIC or 

other federal regulators would provide investors with proprietary information 

on large banks. Still, the FDIC could address this problem by issuing a security with payments linked to deposit insurance losses across all large banks. 

The risk of adverse selection would then be minimized inasmuch as such a 

security would prevent the FDIC from (adversely) selecting only high-risk banks 

for securitization. 

Conclusions 

In an article that anticipated the capital asset pricing model (CAPM), Karl Borch (1962) defined

the Pareto optimal risk-sharing arrangement in the

market for reinsurance. According to Cummins

and Weiss,

In a market in which risk bearing is costly to

firms but where transacting between firms is

costless, the Pareto optimal risk-sharing

arrangement is one in which the industry

"mutualizes" its risk in the sense that all insurers hold the same net (after reinsurance) liability portfolio. According to Borch, the Pareto

optimal reinsurance arrangement is one in

which each insurer holds a net portfolio that is

a proportionate claim on total insured losses.

This result is equivalent to the CAPM proposition that each investor will hold a share of the

market portfolio.32

In a world with no transaction costs, primary

insurers would shed a large amount of their insurance risk by entering into reinsurance contracts.

However, such risk shifting is constrained in the

real world by reinsurance contracts that include

deductibles, coinsurance, and insurance limits.

Deductibles and coinsurance are introduced as a

method of controlling incentive conflicts. "It may

be that the most efficient form of reinsurance is to

allow very little risk transfer at all: it is only by

forcing . . . risk back upon insurers that reinsurers

get insurers to expend resources to monitor and

mitigate exposures."33 A more complete shifting

of risk would involve a movement away from

deductibles and coinsurance; unfortunately, to this

point, addressing moral hazard by alternative

methods has been shown to expose insurers to

unacceptable levels of basis risk. 

The FDIC may find that it can shed a large

amount of risk simply by entering the reinsurance

market. Or the Corporation may find that this

method of risk shifting is severely limited by the

presence of moral-hazard and other problems. In

32 Cummins and Weiss (2000), 165–66. 

33 Froot (1997), 13. 

13 2003, VOLUME 15, NO. 1 
 

FDIC Banking Review 

the latter case, the FDIC may decide to retain its

risk. If the FDIC retains its risk, it may address its

increased exposure from banking consolidation by

increasing the size of the Bank Insurance Fund

(BIF) (currently mandated to equal 1.25 percent

of insured deposits). The appropriate size of the

insurance fund will be hard to determine, but even

so, setting aside huge sums of money for the rare

event of a large-bank failure seems incredibly inefficient. Alternatively, the FDIC can minimize the

funding of the BIF by using contingent capital,

which it can do by increasing its line of credit with

the Treasury (currently set at $30 billion). A larger line of credit will allow the FDIC to cover

potentially huge losses while placing only limited

demands on the economy's finite stock of capital.

Finally, the FDIC may consider increasing capital

requirements of banks. If the Corporation

requires large banks to hold more capital, this

additional capital will not reduce the exposure of

the FDIC to large-bank failure, even though it

may reduce the likelihood that a large bank will

fail. If such an event-although perhaps less likely-occurs, the FDIC will still be exposed to

potentially huge deposit insurance losses. Exposure to such losses requires the FDIC to have

access to a larger pool of capital, and this article

has examined a number of ways that the Corporation might increase its insurance capital.

2003, VOLUME 15, NO. 1 14 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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BIBLIOGRAPHY 

American Academy of Actuaries. 1999. Evaluating the Effectiveness of Index-Based Insurance Derivatives in Hedging Property/Casualty Insurance Transactions. Report of

the Index Securitization Task Force (Washington, DC).

Borch, Karl. 1962. Equilibrium in a Reinsurance Market. Econometrica 30, no. 3:424-44.

Borden, Sara, and Asani Sarkar. 1996. Securitizing Property Catastrophe Risk. Federal

Reserve Bank of New York Current Issues in Economics and Finance 2, no. 9:1-6.

Canter, Michael S., Joseph B. Cole, and Richard L. Sandor. 1997. Insurance Derivatives:

A New Asset Class for the Capital Markets and a New Hedging Tool for the Insurance Industry. Journal of Applied Corporate Finance 10, no. 3:69-83.

Cox, Samuel H., Joseph R. Fairchild, and Hal W. Pedersen. 2000. Economic Aspects of

Securitization of Risk. The Astin Bulletin 30, no. 1:157-93.

Cutler, David M., and Richard J. Zeckhauser. 1997. Reinsurance for Catastrophes and

Cataclysms. NBER Working Paper Series, no. 5913. National Bureau of Economic

Research.

Cummins, J. David. 1991. Statistical and Financial Models of Insurance Pricing and the

Insurance Firm. The Journal of Risk and Insurance 58, no. 2:261-302.

Cummins, J. David, Neil Doherty, and Anita Lo. 2002. Can Insurers Pay for the "Big

One"? Measuring the Capacity of the Insurance Market to Respond to Catastrophic Losses. Journal of Banking & Finance 26, no. 3:557-83. 

Cummins, J. David, David Lalonde, and Richard D. Phillips. 2000. The Basis Risk of Catastrophic-Loss Index Securities. Financial Institutions Center Working Paper

Series, no. 00-22-B. The Wharton School, University of Pennsylvania. 

Cummins, J. David, and Mary A. Weiss. 2000. The Global Market for Reinsurance: Consolidation, Capacity, and Efficiency. Brookings-Wharton Papers on Financial Services

1, no. 1:159-209. 

Doherty, Neil A. 1997. Financial Innovation in the Management of Catastrophe Risk.

Journal of Applied Corporate Finance 10, no. 3:85-95.

Doherty, Neil A., and S. M. Tinic. 1981. Reinsurance Under Conditions of Capital Market

Equilibrium: A Note. Journal of Finance 36, no. 4: 949-53.

Froot, Kenneth. 1997. The Limited Financing of Catastrophe Risk: An Overview. NBER

Working Paper Series, no. 6025. National Bureau of Economic Research.

---. 1999. The Market for Catastrophe Risk: A Clinical Examination. NBER Working Paper Series, no. 7286. National Bureau of Economic Research.

Froot, Kenneth, Brian Murphy, Aaron Stern, and Steven Usher. 1995. The Emerging

Asset Class: Insurance Risk. Guy Carpenter and Company, Special Report.

Greenberg, M. R. 2001. Government Must Be Insurer of Last Resort. Wall Street Journal

138, no. 110: November 26, A18.

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Harrington, Scott E., and Greg Niehaus. 1999. Basis Risk with PCS Catastrophe Insurance Derivative Contracts. Journal of Risk and Insurance 66, no. 1:49-82.

Jaffee, Dwight M., and Thomas Russell. 1997. Catastrophe Insurance, Capital Markets,

and Uninsurable Risk. Journal of Risk and Insurance 64, no. 4:206-30.

Kunreuther, Howard C., and �ivek J. Bantwal. 1999. A Cat Bond Premium Puzzle?

Financial Institutions Center Working Paper Series, no. 99-26. The Wharton

School, University of Pennsylvania. 

Lewis, Christopher M., and Kevin C. Murdock. 1996. The Role of Government Contracts

in Discretionary Reinsurance Markets for Natural Disasters. Journal of Risk and

Insurance 63, no. 4:567-97.

Marsh � McLennan Companies. 2001. Reinsurance Initiative: Federal Deposit Insurance

Corporation. 

--. 2001. Reinsurance Feasibility Study: Federal Deposit Insurance Corporation.

Litzenberger, Robert H., David R. Beaglehole, Craig E. Reynolds. 1996. Assessing Castastrophe Reinsurance-Linked Securities as a New Asset Class. Journal of Portfolio

Management 61, no. 7:76-86.

Niehaus, Greg. 2002. The Allocation of Catastrophe Risk. Journal of Banking & Finance

26, no. 3:585-96.

Swiss Re. 1997. Too Little Reinsurance of Natural Disasters in Many Markets. Sigma

7:3-22. 

Walker, Anna. 1995. Harnessing the Free Market: Reinsurance Models for FDIC Deposit

Insurance Pricing. �arvard Journal of Law & Public Policy 18, no. 3:735-94. 

2003, VOLUME 15, NO. 1 16 
FDIC Banking Review 

Risk Assessment: Results of an 

International Survey of Deposit Insurers 

by Jane E. Coburn and John P. O'Keefe*

The success of the financial safety net that a

country provides for its financial system is ultimately indistinguishable from the ability of government authorities to manage the risks to the

safety net.1 To do their job well, risk managers

need information on the risk exposures of the

financial institutions that are covered by the safety

net, and they also need procedures for limiting

their own risk exposure.

To learn more about how other countries address

these and other important needs of a financial

safety net, in January 2000 the Federal Deposit

Insurance Corporation (FDIC) surveyed 73 foreign deposit insurance organizations in 64 locations (some locations have more than one deposit

insurer). All the organizations had specific deposit

insurance schemes. The survey consisted of 65

multiple­choice and essay questions not only on

* Jane F. Coburn is a senior financial analyst, and John P. O’Keefe is the 

Chief of the Financial Risk Measurement Section in the FDIC’s Division of 

Insurance and Research. The authors thank Christine Brickman and Angela 

Lengyel for research assistance and James Marino for helpful comments. 

1 The financial safety net may be broadly defined as government support of 

private sector borrowers through explicit and implicit guarantees and other 

means (Walter and Weinberg (2002)). Defined in this way, the financial safety net extends to both financial and nonfinancial businesses. This article, 

however, defines the financial safety net more narrowly as the deposit insurance system for banks and thrift institutions. 

risk assessment but also on failure­resolution

methods, asset liquidation and the role of the

receiver, and funds availability. As of June 2000,

37 insurers in 34 locations had responded.2

This is the second in a three­part series on the

results. The first part describes failure­resolution

methods as well as asset­liquidation practices and

the role of the receiver (as reported by the 37 participating deposit insurers).3 This article discusses

the risk­assessment practices of these same insurers, and a subsequent article will address funds

availability (that is, the availability of resources to

absorb unavoidable risk­related losses). The

approach taken throughout the series is to provide

context for survey responses by drawing on the

academic literature and the experiences of the

FDIC.

The majority of the 37 insurers that responded to

the risk­assessment section of the survey are located in Europe. Ten of the 37 respondents-Austria, Belgium, Canada, France, Germany, Italy,

2 Austria, Germany, and Italy have multiple deposit insurers. Not every question was answered by every respondent, so for each question there may have
 

been fewer than 37 responses.
 

3 Bennett (2001).
 

17 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

Japan, the Netherlands, Spain, the United Kingdom-hold 62 percent of the world's banking assets

and encompass 41 percent of the world's gross

domestic product and 15.5 percent of the world's

population. Comparable figures for the United

States are 17.2 percent of the world's banking assets,

28.8 percent of the world's gross domestic product,

and 4.6 percent of the world's population. Borrowing terms from the International Monetary Fund, we

categorize the locations of the respondents as

"advanced economies," "developing economies," or

"economies in transition," but we combine the two

categories of "developing economies" and

"economies in transition" into one.4

In any business, potential creditors and equity

shareholders cannot make sound investment decisions without accurate and timely information on

the condition of, and risks to, the relevant business entities. This need for information creates

incentives for the business entities to prepare and

make public financial statements regularly. The

availability and use of such information are necessary for markets to allocate financial resources efficiently; such allocation makes possible the market

discipline that rewards good management and

punishes bad management.

In banking, however, when countries extend a

safety net to creditors of financial institutions, the

information needs of some creditors are greatly

reduced. More specifically, insured depositors,

who make up the vast majority of the creditors of

most insured banks and thrifts in the United

States, have little incentive to monitor the risks of

insured depositories (henceforth, "banks").5 But

this need for information is not eliminated.

Rather, it is transferred to the deposit insurer,

which stands in place of insured depositors among

banks' creditors when banks fail.6

4 Table 1 lists the survey respondents in their respective categories. 

5 Should a bank fail, insured depositors typically receive full compensation for 

their insured deposits from the FDIC within one to two business days. However, they still face the risk of having to re-deposit their funds in banks that 

offer lower interest rates or charge higher service costs or do both. 

6 To the extent that the deposit insurer (or another government authority) has 

other “safety-net” duties aside from meeting insured depositors’ claims, it 

might have additional needs for information. The additional duties that entail 

additional needs for information include selecting failure-resolution methods, 

acting as receiver and liquidator of failed banks, supervising banks for safety 

Regardless of how countries organize their financial system safety nets, therefore, it is clear that

the government agencies responsible for managing

the safety net need accurate and timely information on the condition of, and risks to, the financial

institutions to which the safety net extends. That

information can come from on­site inspections of

banks and off­site analyses of the financial statements that banks make available to government

authorities and the public.7 In addition, the

responsible agencies must be able to place the

information on banks in its proper economic and

political context. Thus, they require information

about the markets (local, national, and international economic conditions) in which banks operate and about the legislative and other political

developments affecting the environment in which

banks compete. All the information about banks,

their markets, and their competitive environment

enables risk managers to take the next step in the

process of assessing banks' financial health, which

is to forecast bank failures. Finally, the responsible

government agencies must also be concerned with

limiting the deposit insurer's own risk exposurefor example, by terminating deposit insurance or

by closing failed and failing banks. (As mentioned

above, closing failed or failing banks is discussed in

the first article in the series, and the availability of

resources when losses are unavoidable is the subject of the next article.)

Accordingly, the risk­assessment section of the

survey asked whether the deposit insurance organization has access to examination and accounting

information about banks, how information about

economic trends is used, whether legislative or

other political developments are monitored,

whether the health of insured depository institutions is assessed and whether bank failures are

forecasted, and whether deposit insurance is

and soundness, pricing deposit insurance, and managing the insurance fund. 

Those and other additional duties are not discussed in this article. 

Countering these demands for financial disclosure is banks’ need to shield 

their proprietary information from competitors and to protect any proprietary 

information that they require their customers to disclose. In addition, the 

costs and burdens of providing information limit the extent to which it is feasible to disclose information to financial markets and government authorities. 

7 Research on U.S. banks suggests that bank safety-and-soundness examinations (discussed below) provide some important auditing functions that private 

sector auditors do not seem to provide; see Dahl, Hanweck, and O’Keefe (1998). 

2003, VOLUME 15, NO. 1 18 
 

FDIC Banking Review 

Table 1 

Survey Respondents, Summary Statistics, 1999 

Population GDP Banking Industry 

Share of 

Share of Share of World 

Total World World Number Banking Banking 

Population Population Total GDP GDP of Assets Assets 

Deposit Insurer (millions) (percent) (US$ millions) (percent) Banks (US$ billions) (percent) 

Advanced Economies 

Austria 8.18 0.14% $ 208,949 0.69% 844 $ 608.3 1.32% 

Belgium 10.15 0.17 245,706 0.81 84 938.1 2.03 

Canada 30.49 0.52 612,049 2.03 112 584.6 1.27 

France 59.10 1.01 1,410,262 4.67 328 3,506.3 7.59 

Germany 82.09 1.40 2,081,202 6.89 2,517 6,877.7 14.89 

Greece 10.63 0.18 123,934 0.41 28 82.1 0.18 

Isle of Mana 0.08 0.00 985 0.00 49 n.a. n.a. 

Italy 57.34 0.98 1,149,958 3.81 363 2,263.2 4.90 

Japan 126.51 2.15 4,395,083 14.55 177 7,620.0 16.50 

Netherlands 15.81 0.27 384,766 1.27 80 1,328.5 2.88 

Portugal 9.96 0.17 107,716 0.36 50 334.2 0.72 

Spain 39.42 0.67 562,245 1.86 154 1,470.1 3.18 

Sweden 8.86 0.15 226,338 0.75 40 260.1 0.56 

Taiwan Province of China 22.00 0.37 362,000 1.20 49 n.a. n.a. 

United Kingdom 58.74 1.00 1,373,612 4.55 302 3,628.3 7.86 

Subtotal 539.36 9.18% $13,244,805 43.85% 5,177 >$29,501.5 >63.88% 

Developing Economies and Economies in Transition 

Africa 

Nigeria 108.95 1.85 43,286 0.14 81 9.5 0.02 

Tanzania 32.79 0.56 8,777 0.03 10 1.3 0.00 

Uganda 21.62 0.37 6,349 0.02 21 0.9 0.00 

Europe 

Czech Republic 10.28 0.17 56,379 0.19 36 84.5 0.18 

Hungary 10.07 0.17 48,355 0.16 46 26.7 0.06 

Latvia 2.43 0.04 6,664 0.02 25 3.2 0.01 

Lithuania 3.66 0.06 10,454 0.03 11 2.7 0.01 

Poland 38.65 0.66 154,146 0.51 87 76.2 0.17 

Romania 22.46 0.38 33,750 0.11 18 8.0 0.02 

Slovak Republic 5.40 0.09 19,307 0.06 25 15.6 0.03 

Turkey 64.39 1.10 188,374 0.62 67 96.2 0.21 

Middle East 

Bahrain 0.67 0.01 5,350 0.02 36 8.1 0.02 

Oman 2.46 0.04 14,962 0.05 18 9.4 0.02 

Western Hemisphere 

Brazil 163.95 2.79 760,345 2.52 208 286.5 0.62 

El Salvador 6.15 0.10 12,229 0.04 18 7.6 0.02 

Jamaica 2.56 0.04 6,134 0.02 16 4.1 0.01 

Mexico 97.37 1.66 474,951 1.57 63 202.7 0.44 

Peru 25.23 0.43 57,318 0.19 20 20.4 0.04 

Trinidad and Tobago 1.29 0.02 6,998 0.02 17 3.7 0.01 

Subtotal 620.38 10.54% $ 1,914,128 6.34% 823 $ 867.3 1.88% 

Total 1,159.74 19.72 15,158,933 50.18 6,000 >30,368.8 >65.77 

United States 273.13 4.65 8,708,870 28.83 8,907 7,956.9 17.23 

World 5,879.00 100.00% $30,211,993 100.00% n.a. $46,177.5 100.00% 

Note: 

Population—1999 midyear estimates. Source: International Monetary Fund (June 2000), International Financial Statistics. Taiwan Province of China and Isle of Man statistics from CIA (1999), World
 

Factbook.
 

GDP—1999. Source: World Bank, 2000, Development Indicators. Taiwan Province of China and Isle of Man statistics are 1998 estimates from CIA (1999), World Factbook.
 

Banking Industry—Number of banks. Source: Thomson Bank Directory (2000), Thomson Financial Publishing. Banking assets as of 1999: International Monetary Fund (June 2000), International
 

Financial Statistics (bank assets are summations of lines 20 through 22 in the International Financial Statistics, converted to December 1999 U.S. dollars). World total does not include Afghanistan,
 

Dem. Rep. of Congo, People’s Dem. Rep. of Yemen, St. Pierre & Miquelon, and Vietnam. December 1999 data were not available for Djibouti, Greece, Guinea, Republic of Yemen, so data from second-


quarter 1998 were used.
 

aBritish Crown Dependency. 

19 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

revocable. Survey results for each of those topics

are presented below, preceded in each case by a

discussion of important issues and an outline of

the FDIC's practice.

Information on Banks’ Condition and Riskiness 

In the United States, information on banks' condition and riskiness comes from two sources: on­site

examinations and off­site analysis of banks' financial statements (accounting information).

Access to Examination Information

The purpose of examining banks in the United

States is to assess an institution's overall financial

condition, review management practices and policies, monitor adherence with banking laws and

regulations, review internal control systems, identify risks, and uncover fraud or insider abuse. The

FDIC's safety­and­soundness examinations consist

of three­parts: pre­examination planning, on­site

examination, and completion of the report of

examination. Pre­examination planning takes

place off­site at the field office, where the examiner­in­charge completes an analysis and review of

the institution, contacts the institution for financial records, and develops an examination work

plan. During this stage, the examiner­in­charge

decides on areas that need special attention and

on the work that will be done first; these decisions

will make for an efficient and orderly examination.

The examiner­in­charge also notifies the institution of the date when the examination team will

be visiting the bank, typically within the next two

weeks. This interval allows the institution enough

time to respond to any pre­examination requests

for information.

Once the examination team enters the institution,

the examiners concentrate on the institution's

asset quality, financial condition, and operations.

The examination team also evaluates the institution's adherence to banking laws and regulations,

the adequacy of the institution's internal controls

and procedures, and the capability of management

reporting systems to provide reliable and accurate

data.

In 2001, the FDIC employed 1,500 safety­andsoundness examiners to examine 2,640 banks on a

schedule mandated by the Federal Deposit Insurance Act: healthy, small institutions (those with a

composite examination rating of 1 or 2 and less

than $250 million in assets) must be examined

every 18 months, and all larger institutions, as

well as those small institutions whose composite

examination rating is 3, 4, or 5, must be examined

every 12 months.8 The FDIC conducts examinations of all the banks for which it is the primary

regulator, that is, FDIC­insured state­chartered

banks that are not members of the Federal

Reserve System. In most cases involving wellmanaged institutions, however, the FDIC alternates examinations with the respective state

authorities and has entered into agreements with

the state banking departments governing the manner in which examination responsibilities are

shared.

For institutions of which the FDIC is the primary

regulator, therefore, the FDIC determines firsthand if they are in the "problem" category. For

institutions whose primary regulator is another

agency-that is, for national banks, state­chartered banks that are members of the Federal

Reserve System, and savings associations-the

FDIC relies on the examinations conducted by

other regulators to determine a bank's overall condition and the risks posed to the deposit insurance

fund.9 The FDIC is in close contact with the

other regulatory agencies and is constantly aware

8 All federal and state bank examiners use a rating system that focuses on 

six components of the on-site examination findings: capital adequacy, asset 

quality, management, earnings, liquidity, and sensitivity to market risk. Each 

of those components is rated. At the end of the examination, the overall condition of the institution is evaluated and a composite rating from 1 to 5 is 

determined. An institution performing well above average receives a composite rating of 1 (the best rating), and an institution in severe financial difficulties with a strong probability of failure within 12 months receives a composite 

rating of 5 (the worst rating). 

9 Garcia ((2001), 51) states that a deposit insurance agency “should be able 

to request the [relevant] supervisor to undertake a special examination of any 

insured financial institution that [the deposit insurance agency] feels may be 

in financial difficulties. Whether [the deposit insurance agency] staff should 

be able to participate in onsite inspections would vary from country to country.” 

2003, VOLUME 15, NO. 1 20 
FDIC Banking Review 

of their examination activities. Through its case

manager program, the FDIC monitors non­FDICsupervised banks, and the case managers are

responsible for sharing information with other regulators. Thus, whether by direct examination or

by monitoring and sharing information, the FDIC

compiles information, including examination

reports, on all insured banks. Interagency agreements and statements of policy encourage the

process of sharing information. In 1997, the FDIC

issued a policy statement that outlines a program

for sharing examination findings and establishes

guidelines for resolving differences in examination

findings between federal regulators. 

In addition, the FDIC has special backup examination authority for the institutions of which it is

not the primary regulator, and in early 2002 the

federal banking regulators agreed to a process for

determining when the FDIC would use its backup

examination authority. Its backup activities generally take the form of participation in the examinations conducted by the primary federal regulator

or the state authority, or attendance at meetings

where the findings of an examination are discussed. The FDIC's participation in such activities usually involves assessing the potential risk

the particular institution may pose to the deposit

insurance fund. 

The report of examination-the third part of the

examination process-factually presents the

bank's condition, identifies problems, provides

management with suggestions and recommendations, and discloses the examination ratings. The

report of examination, in other words, documents

the results of the examination and the basis on

which the composite rating was determined. This

report is a confidential document shared only with

the institution's senior management and board of

directors, and its contents can be disclosed only

with the FDIC's authorization.

Of the 37 deposit insurers that responded to the

survey, 19 answered "Yes" to the following question: On a regular basis, do you collect or have

access to the report of examination from individual

insured depository institutions? (See Table 2.) Of

the 19 replying yes, 10 were in advanced

economies and 9 were in developing economies

and economies in transition. Only 2 of the 19

receive less than the full report of examination.

Access to Accounting Information

Demirgiic­Kunt and Kane, offering advice to

countries that are considering adopting deposit

insurance systems, write that ". . . upgrading

accounting and disclosure rules so that accurate

information reaches the markets in a timely fashion [exempliflies] the kinds of institution reforms

that improve incentive structures and limit excess

risk­taking."10 To the extent that bank creditors

are not covered by deposit insurance and therefore

seek to exert market discipline, accurate disclosure

of financial information can serve to control

excessive risk taking by banks. Besides uninsured

bank creditors, the deposit insurer that stands in

the place of insured creditors also relies on accurate financial disclosure to manage the insurance

system and limit risks to that system.

U.S. banks are required to file reports of income

and condition with their primary federal bank regulator on a quarterly basis. These reports contain

detailed balance­sheet and income­statement

information, as well as a great deal of supporting

financial information. The financial reports are

available to the public 75 days after the end of

each quarter.11 Net income, equity capital, and

problem loans are readily ascertainable from these

required quarterly reports, as are numerous financial statistics for individual banks and aggregate

values. The FDIC publishes a summary of the

quarterly financial results for FDIC­insured commercial banks and savings institutions in its Quarterly Banking Profile, each issue of which includes

aggregate data on condition and income and on

performance and condition ratios. The FDIC

makes extensive use of these data in pre­examination planning, off­site monitoring programs, assessments of an institution's capital adequacy and

financial strength, and economic research.

10 Demirgi9-Kunt and Kane (2001), 25.
 

11 Some reported information is made available only to bank regulators and is
 

not publicly disclosed.
 

21 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

Table 2
 

Report of Examination 

On a regular basis, do you collect or have

access to the report of examination from Do you receive less than the full

individual insured depository institutions? report of examination?

Deposit Insurer Yes No Yes No 

Advanced Economies 

Austria (AAR) X X
 

Austria (AABB) X X
 

Belguim X X
 

Canada X X
 

France X
 

Germany (EdB) X X
 

Germany (E) X X
 

Greece X
 

Isle of Mana X X
 

Italy (IDPF) X X
 

Italy (DPFCB) X X
 

Japan X X
 

Netherlands X X
 

Portugal X
 

Spain X X
 

Sweden X X
 

Taiwan Province of China X X
 

United Kingdom X
 

Subtotal 10 8 2 12
 

Developing Economies and Economies in Transition 

Africa
 

Nigeria X
 

Europe
 

Middle East
 

Western Hempishere
 

Tanzania X X
 

Uganda X X
 

Czech Republic X X
 

Hungary X X
 

Latvia X X
 

Lithuania X X
 

Poland X X
 

Romania X X
 

Slovak Republic X X
 

Turkey X
 

Bahrain X X
 

Oman X X
 

Brazil X X
 

El Salvador X X
 

Jamaica X X
 

Mexico X X
 

Peru X X
 

Trinidad and Tobago X
 

Subtotal 19 10 4 12
 

Total 19 18 6 24
 

Note: Classification of economies into "Advanced," "Developing,” or "Economies in Transition" is from International Monetary Fund (2000). Deposit insurers without an "X" in either the Yes or No column did not answer the question on the survey or did not provide an answer that was easily categorized as yes or no. 

a British Crown Dependency. 

AAR = Association of Austrian Raiffesenbanks 

AABB = Association of Austrian Banks and Bankers 

EdB = Entschadigungseinrichtung deutscher Banken 

E = Einlagensicherungs 

IDPF = Interbank Deposit Protection Fund 

DPFCB = Deposit Protection Fund for Co-operative Banks 

2003, VOLUME 15, NO. 1 22
 
FDIC Banking Review 

The data are also publicly available at the FDIC's

Web site through two products: Institution Directory and Statistics on Depository Institutions. The

Institution Directory provides a comprehensive

financial profile of each FDIC­insured bank, and

the Statistics on Depository Institutions provide

detailed financial reports that enable the user to

analyze the banking industry. The user can create

reports containing customized peer groups of

FDIC­insured banks and bank holding companies.

Demographic data are available, along with an

institution's most­recent quarterly financial statement and performance ratios.

Most insurers that responded to the survey regularly receive balance­sheet and income data from

banks. Of the 37 respondents to the following

survey question, 27 replied "Yes": On a regular

basis, do you collect or have access to regularly reported balance­sheet and income data from individual

insured depository institutions? (See Table 3.) Of

those replying yes, 13 were in advanced economies

and 14 were in developing economies and

economies in transition.

Effective March 31, 1997, generally accepted

accounting principles (GAAP) were adopted as

the reporting basis for the balance sheet, income

statement, and supporting schedules for U.S.

banks. According to Garcia, "Internationally

accepted accounting and auditing standards will

facilitate realistic loan valuations and empower

market discipline."12 Of the 26 respondents to

the following survey question, 21 answered "Yes":

Do these data [balance sheet, etc.] meet internationally accepted accounting standards? (See Table 4.) Of

the 21 that answered yes to the question, 10 operate in advanced economies and 11 in developing

economies and economies in transition.13

The survey also queried deposit insurers about

their ability to determine net income, equity capital, and troubled loans. The FDIC is able to

12 Garcia (2001), 19. 

13 Significant differences exist between U.S. generally accepted accounting 

standards and internationally accepted accounting standards. The U.S. Securities and Exchange Commission requires financial statements that were prepared in accordance with international accounting standards to be reconciled 

with the U.S. GAAP. 

determine these values for all FDIC­insured banks

on a quarterly basis, and most foreign deposit

insurers are able to determine them as well. Of

the 26 respondents to the following survey question, 23 answered "Yes": Do these data allow you to

accurately determine the insured depository institution's net income? (See Table 5.) Of the 23 that

answered yes, 10 operate in advanced economies

and 13 in developing economies and economies in

transition. Of the 26 respondents to the following

survey question, 24 answered "Yes": Do these data

allow you to calculate an accurate level of the insured

depository institution's equity capital or surplus? (See

Table 6.) Of the 24 that answered yes, 10 operate

in advanced economies and 14 in developing

economies and economies in transition. Of the 25

respondents to the following survey question, 18

answered "Yes": Do these data include the amount

of the insured depository institution's troubled or pastdue loans? (See Table 7.) Of the 18 that answered

yes, 8 operate in advanced economies and 10 in

developing economies and economies in transition.

Information on the Economic and Political 

Contexts 

Obtaining accurate and timely information on

banks is the first step for risk assessment. The second step is understanding that information in the

economic and political contexts of bank operations. The goal, of course, is to use that information in a systematic way that permits one to assess

the health of insured depository institutions.

Analysis of Local, National, and International

Economic Trends

The nonfinancial and financial segments of the

economy are interdependent. On the one hand,

consumers and businesses-the nonfinancial segments-rely on financial intermediaries and direct

credit markets to finance expenditures; financial

intermediaries support the payments system; and a

significant increase in the cost of credit or in the

non­price rationing of credit can adversely affect

the financial condition of consumers and business23 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

Table 3 

Accounting Information 

On a regular basis, do you collect or have access to regularly reported balance-sheet

and income data? If yes, how frequently are these data reported?
 

Deposit Insurer Yes No Frequency 

Advanced Economies 

Austria (AAR) X Four per year 

Austria (AABB) X Monthly or quarterly plus annual report 

Belguim X Annually 

Canada X Varies 

France X 

Germany (EdB) X 

Germany (E) X 

Greece X 

Isle of Mana X Quarterly Banking Returns 

Italy (IDPF) X Semiannually for banks in Order; quarterly for banks in ”watch” 

Italy (DPFCB) X Semiannually for Cooperative Banks; quarterly for banks in “watch” 

Japan X 

Netherlands X Monthly balance-sheet data; yearly income data 

Portugal X Average amount of monthly credit balances is reported annually 

Spain X 

Sweden X 

Taiwan Province of China X Quarterly 

United Kingdom X Annual Report and Accounts 

Subtotal 13 5 

Developing Economies and Economies in Transition 

Africa 

Nigeria X Varies 

Tanzania X Monthly 

Uganda X Monthly balance sheets, quarterly statements, annual final accounts 

Europe 

Czech Republic X 

Hungary X Quarterly 

Latvia X 

Lithuania X Quarterly 

Poland X Monthly, quarterly 

Romania X 

Slovak Republic X 

Turkey X Quarterly 

Middle East 

Bahrain X 

Oman X Quarterly 

Western Hempishere 

Brazil X Monthly 

El Salvador X Monthly 

Jamaica X Monthly balance-sheet data; quarterly income data 

Mexico X Quarterly 

Peru X Monthly 

Trinidad and Tobago X Published Annual Reports 

Subtotal 14 5 

Total 27 10 

Note: Classification of economies into "Advanced," "Developing,” or "Economies in Transition" is from International Monetary Fund (2000). Deposit insurers without an "X" in either the Yes or No col­ umn did not answer the question on the survey or did not provide an answer that was easily categorized as yes or no. 

a British Crown Dependency. 

AAR = Association of Austrian Raiffesenbanks 

AABB = Association of Austrian Banks and Bankers 

EdB = Entschadigungseinrichtung deutscher Banken 

E = Einlagensicherungs 

IDPF = Interbank Deposit Protection Fund 

DPFCB = Deposit Protection Fund for Co-operative Banks 

2003, VOLUME 15, NO. 1 24 
FDIC Banking Review 

Table 4 Table 5
 

Accounting Standards Net Income 

Do these data [balance sheet, etc.] Do these data allow you to accurately meet internationally accepted determine the insured depository accounting standards? institution's net income?

Deposit Insurer Yes No Deposit Insurer Yes No 

Advanced Economies Advanced Economies 

Austria (AAR) X Austria (AAR) X
 

France France
 

Greece Greece
 

Japan Japan
 

Spain Spain
 

Sweden Sweden
 

United Kingdom United Kingdom
 

Austria (AABB) X Austria (AABB) X
 

Belguim X Belguim X
 

Canada X Canada X
 

Germany (EdB) X Germany (EdB) X
 

Germany (E) X Germany (E) X
 

Isle of Mana X Isle of Mana X
 

Italy (IDPF) X Italy (IDPF) X
 

Italy (DPFCB) X Italy (DPFCB) X
 

Netherlands X Netherlands X
 

Portugal X Portugal X
 

Taiwan Province of China X Taiwan Province of China X
 

Subtotal 10 2 Subtotal 10 2
 

Developing Economies and Economies in Transition Developing Economies and Economies in Transition 

Africa Africa
 

Nigeria X Nigeria X
 

Europe Europe
 

Czech Republic Czech Republic
 

Latvia Latvia
 

Romania Romania
 

Slovak Republic Slovak Republic
 

Middle East Middle East
 

Bahrain Bahrain
 

Western Hempishere Western Hempishere
 

Tanzania X Tanzania X
 

Uganda X Uganda X
 

Hungary X Hungary X
 

Lithuania X Lithuania X
 

Poland X Poland X
 

Turkey X Turkey X
 

Oman X Oman X
 

Brazil X Brazil X
 

El Salvador X El Salvador X
 

Jamaica X Jamaica X
 

Mexico X Mexico X
 

Peru X Peru X
 

Trinidad and Tobago X Trinidad and Tobago X
 

Subtotal 11 3 Subtotal 13 1
 

Total 21 5 Total 23 3
 

Note: Classification of economies into "Advanced," "Developing,” or "Economies in Transition" is Note: Classification of economies into "Advanced," "Developing,” or "Economies in Transition" is from International Monetary Fund (2000). Deposit insurers without an "X" in either the Yes or from International Monetary Fund (2000). Deposit insurers without an "X" in either the Yes or No column did not answer the question on the survey or did not provide an answer that was No column did not answer the question on the survey or did not provide an answer that was easily categorized as yes or no. easily categorized as yes or no. a British Crown Dependency. a British Crown Dependency. 

AAR = Association of Austrian Raiffesenbanks AAR = Association of Austrian Raiffesenbanks 

AABB = Association of Austrian Banks and Bankers AABB = Association of Austrian Banks and Bankers 

EdB = Entschadigungseinrichtung deutscher Banken EdB = Entschadigungseinrichtung deutscher Banken 

E = Einlagensicherungs E = Einlagensicherungs 

IDPF = Interbank Deposit Protection Fund IDPF = Interbank Deposit Protection Fund 

DPFCB = Deposit Protection Fund for Co-operative Banks DPFCB = Deposit Protection Fund for Co-operative Banks 

25 2003, VOLUME 15, NO. 1
 
FDIC Banking Review 

Table 6
 

Equity Capital or Surplus 

Do these data allow you to calculate an

accurate level of the insured depository

institution's equity capital or surplus?

Deposit Insurer Yes No 

Advanced Economies 

Austria (AAR) X
 

Austria (AABB) X
 

Belguim X
 

Canada X
 

France
 

Germany (EdB) X
 

Germany (E) X
 

Greece
 

Isle of Mana X
 

Italy (IDPF) X
 

Italy (DPFCB) X
 

Japan
 

Netherlands X
 

Portugal X
 

Spain
 

Sweden
 

Taiwan Province of China X
 

United Kingdom
 

Subtotal 10 2
 

Developing Economies and Economies in Transition 

Africa
 

Nigeria X
 

Tanzania X
 

Uganda X
 

Europe
 

Czech Republic
 

Hungary X
 

Latvia
 

Lithuania X
 

Poland X
 

Romania
 

Slovak Republic
 

Turkey X
 

Middle East
 

Bahrain
 

Oman X
 

Western Hempishere
 

Brazil X
 

El Salvador X
 

Jamaica X
 

Mexico X
 

Peru X
 

Trinidad and Tobago X
 

Subtotal 14 0 

Total 24 2
 

Note: Classification of economies into "Advanced," "Developing,” or "Economies in Transition" is from International Monetary Fund (2000). Deposit insurers without an "X" in either the Yes or

No column did not answer the question on the survey or did not provide an answer that was

easily categorized as yes or no. 

a British Crown Dependency. 

AAR = Association of Austrian Raiffesenbanks 

AABB = Association of Austrian Banks and Bankers 

EdB = Entschadigungseinrichtung deutscher Banken 

E = Einlagensicherungs 

IDPF = Interbank Deposit Protection Fund 

DPFCB = Deposit Protection Fund for Co-operative Banks 

Table 7
 

Troubled or Past-Due Loans 

Do these data include the amount of

the insured depository institution's

troubled or past-due loans?

Deposit Insurer Yes No 

Advanced Economies 

Austria (AAR) X
 

Austria (AABB) X
 

Belguim
 X
 

Canada
 X
 

France
 

Germany (EdB) X
 

Germany (E) X
 

Greece
 

Isle of Mana X
 

Italy (IDPF) X
 

Italy (DPFCB) X
 

Japan
 

Netherlands X
 

Portugal X
 

Spain
 

Sweden
 

Taiwan Province of China X
 

United Kingdom
 

Subtotal 8 4
 

Developing Economies and Economies in Transition 

Africa
 

Nigeria X
 

Tanzania X
 

Uganda X
 

Europe
 

Czech Republic
 

Hungary X
 

Latvia
 

Lithuania X
 

Poland X
 

Romania
 

Slovak Republic
 

Turkey X
 

Middle East 

Bahrain 

Oman 

Western Hempishere
 

Brazil X
 

El Salvador X
 

Jamaica X
 

Mexico X
 

Peru X
 

Trinidad and Tobago X
 

Subtotal 10 3
 

Total 18 7
 

Note: Classification of economies into "Advanced," "Developing,” or "Economies in Transition" is from International Monetary Fund (2000). Deposit insurers without an "X" in either the Yes or

No column did not answer the question on the survey or did not provide an answer that was

easily categorized as yes or no. 

a British Crown Dependency. 

AAR = Association of Austrian Raiffesenbanks 

AABB = Association of Austrian Banks and Bankers 

EdB = Entschadigungseinrichtung deutscher Banken 

E = Einlagensicherungs 

IDPF = Interbank Deposit Protection Fund 

DPFCB = Deposit Protection Fund for Co-operative Banks 

2003, VOLUME 15, NO. 1 26
 
 

FDIC Banking Review 

es, as can a serious disruption of the payments system. On the other hand, national and regional

economic recessions and declines in sectors of the

economy (for example, agriculture, real estate, or

other commodity or service markets) can negatively affect the financial segment by impairing

borrowers' ability to repay loans, thus causing

lenders' financial condition to deteriorate. Similar

concerns apply to international markets, given the

importance of foreign trade and finance to sectors

of the domestic economy. For these reasons,

deposit insurers might have an interest in monitoring local, national, and international economic

trends. Moreover, deposit insurers might be interested in how those trends could affect banks. 

In 1995, the FDIC took steps to more actively

address market trends and emerging risks before

they become problems for banks.14 From the

unique perspective of the deposit insurer, the

FDIC began to analyze more closely the risks to

the deposit insurance fund and translated this

analysis into guidance for examiners and bankers.

Developing a dynamic approach that combined

traditional examination methods and new initiatives, the FDIC sought to (1) identify major problems, national or regional, that might threaten the

viability of the bank insurance fund, and (2) mitigate the adverse effects that future events might

have on the financial health of banks.

The FDIC continues to assess local, national, and

international economic trends to determine their

implications for banks and for the deposit insurance fund. The FDIC identifies and monitors

existing and emerging risks and translates this

information into specific and useful guidance for

its examination workforce. The FDIC's analysts

work closely with examiners, providing comprehensive regional economic data and analyses to

help them assess emerging risk exposures for individual banks and groups of banks.

The FDIC also employs subject­matter experts

who collect and analyze data and monitor economic and financial risks. These subject­matter

experts study many areas, including the global

economy and country exposures, the domestic

economy, industry sectors, capital markets, underwriting standards, and commercial real estate.

This information is published in numerous reports

and surveys that are available to bankers, the public, and government oversight groups.

The majority of the deposit insurers surveyed do

not regularly assess local, national, and international economic trends. Of the 37 respondents to

the following question, 14 answered "Yes": Do you

regularly assess local, national, and international economic trends to determine their implications for

insured depository institutions? (See Table 8.) Of

the 14 that answered yes, 6 operate in advanced

economies and 8 in developing economies and

economies in transition.

Analysis of Legislative and Other Political

Developments

The legal and political environment in which

banks operate can influence their financial condition indirectly and directly. In the United States,

changes in federal and state laws in areas that

have a direct influence on consumers and businesses can affect banks indirectly. For example, a

change in federal tax law on real estate investments in 1986 was one factor that contributed to

the decline in real estate markets in the late

1980s, and this decline in turn contributed to the

subsequent failures of banks with large loan concentrations in commercial real estate development.15 Alternatively, regulation of banking

activities is often used as a direct means of promoting the health and stability of the banking

industry. For example, regulatory capital requirements are defined in terms of minimum capitalization standards for safe and sound banks, and

banks that are not safe and sound have higher

capital requirements.

The FDIC's Office of Legislative Affairs interacts

with Congress and publishes a weekly report

14 FDIC (1995), 31. 15 FDIC (1997), 1:140–41. 

27 2003, VOLUME 15, NO. 1 
 

FDIC Banking Review 

Table 8
 

Economic Trends 

Do you regularly assess local, national,

and international economic trends to
 determine their implications for

insured depository institutions?
 

Deposit Insurer Yes No 

Advanced Economies 

Austria (AAR) X
 

Austria (AABB) X
 

Belguim X
 

Canada X
 

France X
 

Germany (EdB) X
 

Germany (E) X
 

Greece X
 

Isle of Mana X
 

Italy (IDPF) X
 

Italy (DPFCB) X
 

Japan X
 

Netherlands X
 

Portugal X
 

Spain X
 

Sweden X
 

Taiwan Province of China X
 

United Kingdom X
 

Subtotal 6 12
 

Developing Economies and Economies in Transition 

Africa
 

Nigeria X
 

Tanzania X
 

Uganda X
 

Europe
 

Czech Republic X
 

Hungary X
 

Latvia X
 

Lithuania X
 

Poland X
 

Romania X
 

Slovak Republic X
 

Turkey X
 

Middle East
 

Bahrain X
 

Oman X
 

Western Hempishere
 

Brazil X
 

El Salvador X
 

Jamaica X
 

Mexico X
 

Peru X
 

Trinidad and Tobago X
 

Subtotal 8 11
 

Total 14 23
 

Note: Classification of economies into "Advanced," "Developing,” or "Economies in Transition" is from International Monetary Fund (2000). Deposit insurers without an "X" in either the Yes or

No column did not answer the question on the survey or did not provide an answer that was

easily categorized as yes or no. 

a British Crown Dependency. 

AAR = Association of Austrian Raiffesenbanks 

AABB = Association of Austrian Banks and Bankers 

EdB = Entschadigungseinrichtung deutscher Banken 

E = Einlagensicherungs 

IDPF = Interbank Deposit Protection Fund 

DPFCB = Deposit Protection Fund for Co-operative Banks 

describing current congressional activities affecting banks. The FDIC's Chairman frequently testifies about topics of concern to Congress, especially

topics important for congressional oversight of the

FDIC.

The responses to the survey of deposit insurers

indicate that a majority of respondents monitor

legislative or other political developments. Of the

37 deposit insurers that responded to the following survey question, 33 answered "Yes": Do you

routinely monitor legislative or other political developments that may have implications for insured depository institutions? (See Table 9.) Of the 33 that

answered yes, 15 operate in advanced economies

and 18 in developing economies and economies in

transition.

Use of Information to Forecast 

Potential Failures 

As mentioned above, risk management assumes

that the goal of collecting and analyzing information is to assess the health of insured depository

institutions.16 A subset of assessing health is forecasting potential failures, for it is inevitable that

some banks will fail. Between 1980 and 1994 the

United States saw the failure of more than 1,600

FDIC­insured banks, holding $206 billion in assets

and constituting 9 percent of the assets of all U.S.

insured depository institutions.17 In 1988 the

FDIC suffered its first operating­income loss; the

losses continued through 1991, totaling $25.3 billion for the four­year period.18

The FDIC is, however, responsible (but not solely)

for minimizing the financial cost of bank failures,

and one way to do this is to identify financially

troubled banks and intervene before failure

occurs. Thus, using examination and financial

data and off­site monitoring programs and systems

16 Many of the survey respondents are able to assess the health of insured 

depository institutions. Of the 35 respondents to the following survey question, 20 answered “Yes”: Do you use the data available to you to regularly 

assess the health of insured depository institutions? (See Table 10.) Eleven 

of the “Yes” respondents operate in advanced economies and 9 in developing 

economies and economies in transition. 

17 FDIC (1997), 15. 

18 FDIC (2000a), 109. 

2003, VOLUME 15, NO. 1 28
 
FDIC Banking Review 

Table 9
 

Legislative and Other Political 

Developments 

Do you routinely monitor legislative or

other political developments that may

have implications for insured

depository insitutions?

Deposit Insurer Yes No 

Advanced Economies 

Austria (AAR) X
 

Austria (AABB) X
 

Belguim X
 

Canada X
 

France X
 

Germany (EdB) X
 

Germany (E) X
 

Greece X
 

Isle of Mana X
 

Italy (IDPF) X
 

Italy (DPFCB) X
 

Japan X
 

Netherlands X
 

Portugal X
 

Spain X
 

Sweden X
 

Taiwan Province of China X
 

United Kingdom X
 

Subtotal 15 3
 

Developing Economies and Economies in Transition 

Africa
 

Nigeria X
 

Tanzania X
 

Uganda X
 

Europe
 

Czech Republic X
 

Hungary X
 

Latvia X
 

Lithuania X
 

Poland X
 

Romania X
 

Slovak Republic X
 

Turkey X
 

Middle East
 

Bahrain X
 

Oman X
 

Western Hempishere
 

Brazil X
 

El Salvador X
 

Jamaica X
 

Mexico X
 

Peru X
 

Trinidad and Tobago X
 

Subtotal 18 1
 

Total 33 4
 

Note: Classification of economies into "Advanced," "Developing,” or "Economies in Transition" is from International Monetary Fund (2000). Deposit insurers without an "X" in either the Yes or

No column did not answer the question on the survey or did not provide an answer that was

easily categorized as yes or no. 

a British Crown Dependency. 

AAR = Association of Austrian Raiffesenbanks 

AABB = Association of Austrian Banks and Bankers 

EdB = Entschadigungseinrichtung deutscher Banken 

E = Einlagensicherungs 

IDPF = Interbank Deposit Protection Fund 

DPFCB = Deposit Protection Fund for Co-operative Banks 

Table 10
 

Assessment of Health of 

Institutions 

Do you use the data available to you 

to regularly assess the health of

insured depository institutions?

Deposit Insurer Yes No 

Advanced Economies 

Austria (AAR) X
 

Austria (AABB) X
 

Belguim X
 

Canada X
 

France X
 

Germany (EdB) X
 

Germany (E) X
 

Greece X
 

Isle of Mana X
 

Italy (IDPF) X
 

Italy (DPFCB) X
 

Japan X
 

Netherlands X
 

Portugal X
 

Spain X
 

Sweden X
 

Taiwan Province of China X
 

United Kingdom X
 

Subtotal 11 7
 

Developing Economies and Economies in Transition 

Africa
 

Nigeria X
 

Tanzania X
 

Uganda X
 

Europe
 

Czech Republic
 

Hungary X
 

Latvia X
 

Lithuania X
 

Poland X
 

Romania X
 

Slovak Republic X
 

Turkey X
 

Middle East
 

Bahrain
 

Oman X
 

Western Hempishere
 

Brazil X
 

El Salvador X
 

Jamaica X
 

Mexico X
 

Peru X
 

Trinidad and Tobago X
 

Subtotal 9 8
 

Total 20 15
 

Note: Classification of economies into "Advanced," "Developing,” or "Economies in Transition" is from International Monetary Fund (2000). Deposit insurers without an "X" in either the Yes or

No column did not answer the question on the survey or did not provide an answer that was

easily categorized as yes or no. 

a British Crown Dependency. 

AAR = Association of Austrian Raiffesenbanks 

AABB = Association of Austrian Banks and Bankers 

EdB = Entschadigungseinrichtung deutscher Banken 

E = Einlagensicherungs 

IDPF = Interbank Deposit Protection Fund 

DPFCB = Deposit Protection Fund for Co-operative Banks 

29 2003, VOLUME 15, NO. 1
 
FDIC Banking Review 

to identify problem institutions, the FDIC's Financial Risk Committee meets quarterly to project the

cost of bank failures that may occur in the next

year. (Although the committee meets quarterly,

failure projections are prepared more often than

quarterly, and off­site monitoring is conducted

continually.) The committee's primary function is

to set a loss reserve for anticipated failures of

FDIC­insured banks. The committee also identifies areas of risk to the industry, assesses the level

of risk among banks, and meets with other federal

banking regulators to discuss risk exposures, compare trends, and review adverse events to determine their implications for various approaches to

risk.

If a country funds deposit insurance before failure

losses are incurred, the insurer needs to forecast

insurance losses and provide at a minimum for

expected losses.19 If the insurer has duties related

to providing insurance-resolving failed banks,

liquidating assets, and managing receivershipsfailure forecasts might assist in planning for these

other duties as well. If the insurer has duties not

related to providing insurance-conducting monetary policy or fiscal policy or both-failure forecasts might be useful to the extent that failures

would disrupt financial markets and the economy.20

Of the 37 respondents to the following survey

question, 12 answered "Yes": Do you have a committee or group that meets regularly whose mission is

to forecast potential insured depository institution failures? (See Table 11.) Of the 12 that answered

yes, 6 operate in advanced economies and 6 oper19 If deposit insurance is funded after failure losses are incurred, the insurer 

might still need to predict bank failures. If insurance losses are fully funded 

by the government, forecasts might be needed for government budget planning; and if insurance losses are fully funded by banks, banks might also 

need forecasts for budgetary reasons. 

20 The Federal Deposit Insurance Act has provisions to ensure that failure resolutions do not seriously disrupt financial markets and the economy. If written recommendations from the FDIC Board of Directors, the Board of 

Governors of the Federal Reserve System, and the secretary of the U.S. 

Department of the Treasury (in consultation with the president) indicate that 

the use of regular statutory (least-cost) failure-resolution procedures might 

have serious adverse effects on economic conditions or financial stability, a 

less-disruptive procedure must be used even if it increases the costs of resolution. 

Table 11
 

Forecasting Failures 

Do you have a committee or group

that meets regularly whose mission

is to forecast potential insured

depository institution failures?

Deposit Insurer Yes No 

Advanced Economies 

Austria (AAR) X
 

Austria (AABB) X
 

Belguim X
 

Canada X
 

France X
 

Germany (EdB) X
 

Germany (E) X
 

Greece X
 

Isle of Mana X
 

Italy (IDPF) X
 

Italy (DPFCB) X
 

Japan X
 

Netherlands X
 

Portugal X
 

Spain X
 

Sweden X
 

Taiwan Province of China X
 

United Kingdom X
 

Subtotal 6 12
 

Developing Economies and Economies in Transition 

Africa
 

Nigeria X
 

Tanzania X
 

Uganda X
 

Europe
 

Czech Republic X
 

Hungary X
 

Latvia X
 

Lithuania X
 

Poland X
 

Romania X
 

Slovak Republic X
 

Turkey X
 

Middle East
 

Bahrain X
 

Oman X
 

Western Hempishere
 

Brazil X
 

El Salvador X
 

Jamaica X
 

Mexico X
 

Peru X
 

Trinidad and Tobago X
 

Subtotal 6 13
 

Total 12 25
 

Note: Classification of economies into "Advanced," "Developing,” or "Economies in Transition" is from International Monetary Fund (2000). Deposit insurers without an "X" in either the Yes or

No column did not answer the question on the survey or did not provide an answer that was

easily categorized as yes or no. 

a British Crown Dependency. 

AAR = Association of Austrian Raiffesenbanks 

AABB = Association of Austrian Banks and Bankers 

EdB = Entschadigungseinrichtung deutscher Banken 

E = Einlagensicherungs 

IDPF = Interbank Deposit Protection Fund 

DPFCB = Deposit Protection Fund for Co-operative Banks 

2003, VOLUME 15, NO. 1 30
 
FDIC Banking Review 

ate in developing economies and economies in

transition.

Procedures to Limit the Insurer’s Risk Exposure: 

Terminating Deposit Insurance 

Once potential failures are forecast, the question

becomes whether the government authorities

charged with managing the financial safety net

can take active measures to limit the risks to

which these failures will expose them. The primary means of preventing failures is to use bank

regulation and supervision to promote safe and

sound banking practices, but when those measures

fail to rein in unsafe or unsound practices, more

severe action is needed. Although such actions

can take many forms, Garcia recommends 

"[giving] the supervisor a system of prompt remedial actions."21

The most serious remedial action available to the

FDIC is to terminate deposit insurance. Because

deposit insurance is so important to a bank's ability to attract deposits, termination of deposit insurance can effectively lead to a bank's closing. A

proposal to terminate deposit insurance can be

used as a remedial measure-a final attempt to

encourage a bank's management to improve its

financial condition and alter its banking practices,

especially if bank management has previously not

cooperated with supervisory officials. If the bank

is unable to improve its financial condition, however, terminating deposit insurance can reduce

failure­resolution costs.

Deposit insurance can be terminated in two ways:

involuntarily (the FDIC initiates it) and voluntarily (the bank initiates it). The standard for involuntary termination of deposit insurance is high

and involves either unsafe and unsound banking

conditions or practices or violations of laws or regulations (for example, crimes of money laundering,

engaging in monetary transactions in property

derived from specific unlawful activities, and

21 Garcia (2001), 11. 

structuring transactions to evade reporting

requirements). Involuntary termination of deposit

insurance does not occur if (1) the financial institution will be closed within the next 90 days, (2)

open­bank assistance is possible, or (3) the financial institution is actively seeking new capital.

Initially, the FDIC will notify the bank's primary

regulator (and send a copy to the bank) of the

facts and circumstances underlying the proposed

termination and the specific corrective actions

needed, and will state that corrections must occur

in the next 30 days. If the bank does not correct

the problems, the FDIC issues a notice of intent to

terminate insured status. The notice gives the

reasons for terminating insurance and lists a hearing date, which is usually within 120 days of the

notice, although the applicable statute allows for a

hearing date within 30 days of the notice.

If the bank contests the notice, an administrative

law judge will hear the case (hearings are open to

the public) and will decide whether the FDIC may

proceed to terminate insurance. �owever, this

decision is a recommendation, not a final ruling.

The administrative law judge is not involved in

the case after this hearing.

When terminating deposit insurance, the FDIC

may issue a temporary order suspending insurance,

usually within 10 days of the vote of the FDIC

Board of Directors to terminate insurance. Temporary suspension of insurance addresses certain

emergency situations that cannot wait for a formal

hearing date, and an expedited hearing takes place

as soon as possible. In these situations the FDIC

must have evidence of either abnormal risk of loss

or damage to the insurance fund. The temporary

suspension order reduces the risk that the insurance fund will suffer losses while the procedures

for a permanent order are being followed.

Banks have a right to judicial review of enforcement actions in the court of appeals. Unless the

court of appeals or the FDIC Board of Directors

changes the enforcement action, the FDIC will

pursue its termination of deposit insurance. The

FDIC will notify depositors that their deposits will

31 2003, VOLUME 15, NO. 1 
 

FDIC Banking Review 

remain insured for a certain period between six

months and two years (the FDIC Board usually

selects two years).

When a bank is notified that its deposit insurance

will be terminated, the bank may ask to enter into

two agreements with the FDIC-a settlement

agreement and a procedure agreement. The settlement agreement states that if changes do not

occur within a short, fixed period, the bank agrees

to the termination order and waives its legal right

to challenge the action. The procedure agreement clearly defines the changes referred to in the

settlement agreement and the way in which

depositors will be notified if insurance is terminated.

The FDIC is the only U.S. bank regulator with the

authority to terminate federal deposit insurance.

It uses this authority sparingly and, with respect to

unsafe and unsound banking conditions or practices, only when a bank is unable to correct its

financial problems. Garcia states that "the supervisor or the [deposit insurance agency] will have

strong powers to deal in a strict manner with nonviable banks, terminate the interests of shareholders, and impose 'haircuts' on uninsured depositors

and unsecured creditors."22 The FDIC's authority

to terminate deposit insurance is quite different

from the authority of the deposit insurers that

responded to the survey. Few deposit insurers outside the United States have the authority to

revoke deposit insurance in cases in which an

insured depository institution is operating in an

unsafe and unsound manner. Of the 36 deposit

22 Garcia (2001), 53. “Haircuts” is generally defined as full or partial losses 

on uninsured deposits when a bank fails. 

insurers that responded to the following survey

question, 11 answered "Yes": Does the deposit

insurer have the authority to revoke deposit insurance

in cases where an insured depository institution is

operating in an unsafe and unsound manner? (See

Table 12.) Of the 11 that answered yes, 7 operate

in advanced economies and 4 in developing

economies and economies in transition; only 2 of

the respondents--both in advanced economieshad ever used this authority.

Summary 

The results of the survey indicate both similarities

and differences between foreign deposit insurers

and the FDIC. The similarities begin with access

to information: one­half of the foreign deposit

insurers that responded to the survey have access

to reports of examination, and three­quarters regularly receive reported balance­sheet and income

data. These financial data meet internationally

accepted accounting standards; and most of the

respondents are able to determine net income,

equity capital, and troubled loans. Overwhelmingly the respondents follow legislative and other

political developments. As a result, more than 50

percent of the respondents are able to assess the

financial health of banks. 

The differences mainly involve how information is

used in risk assessment. Most deposit insurers

that responded to the survey do not forecast

potential bank failures nor do they follow economic trends. In addition, most respondents do not

have the authority to terminate deposit insurance. 

2003, VOLUME 15, NO. 1 32 
FDIC Banking Review 

Table 12
 

Termination of Deposit Insurance 

Does the deposit insurer have the authority to revo�e If yes, has this

deposit insurance in cases where an insured depository authority ever been

institution is operating in an unsafe or unsound manner? used?

Deposit Insurer Yes No Yes No 

Advanced Economies 

Austria (AAR) X
 

Austria (AABB) X
 

Belguim X
 

Canada X X
 

France X
 

Germany (EdB) X
 

Germany (E) X X
 

Greece X X
 

Isle of Mana X
 

Italy (IDPF) X X
 

Italy (DPFCB) X X
 

Japan X
 

Netherlands X
 

Portugal X
 

Spain X
 

Sweden X
 

Taiwan Province of China X
 

United Kingdom X X
 

Subtotal 7 11 2 4
 

Developing Economies and Economies in Transition 

Africa
 

Nigeria X X
 

Europe
 

Hungary
 

Middle East
 

Western Hempishere
 

Tanzania X X
 

Uganda X
 

Czech Republic X
 

Latvia X
 

Lithuania X X
 

Poland X
 

Romania X
 

Slovak Republic X
 

Turkey X
 

Bahrain X
 

Oman X X
 

Brazil X
 

El Salvador X
 

Jamaica X
 

Mexico X
 

Peru X
 

Trinidad and Tobago X
 

Subtotal 4 14 0 4
 

Total 11 25 2 8
 

Note: Classification of economies into "Advanced," "Developing,” or "Economies in Transition" is from International Monetary Fund (2000). Deposit insurers without an "X" in either the Yes or No column did not answer the question on the survey or did not provide an answer that was easily categorized as yes or no. 

a British Crown Dependency. 

AAR = Association of Austrian Raiffesenbanks 

AABB = Association of Austrian Banks and Bankers 

EdB = Entschadigungseinrichtung deutscher Banken 

E = Einlagensicherungs 

IDPF = Interbank Deposit Protection Fund 

DPFCB = Deposit Protection Fund for Co-operative Banks 

33 2003, VOLUME 15, NO. 1 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

FDIC Banking Review 

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Analysis Working Paper 2002­2. OCC.

Bennett, Rosalind L. 2001. Failure Resolution and Asset Liquidation: Results of an

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Cull, Robert, Lemma W. Senbet, and Marco Sorge. 2001. Deposit Insurance and Financial Development. Policy Research Working Paper no. 2682. World Bank.

Dahl, Drew, Gerald A. �anweck, and John P. O'Keefe. 1998. The Influence of Examiners and Auditors on Loan­Loss Recognition. EDIC Banking Review 11, 

no. 4:1-25. 

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35 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

Recent Developments Affecting 

Depository Institutions 

by Lynne Montgomery*

REGULATORY AGENCY ACTIONS 

Interagency Actions 

Final Rule on Recourse Obligations and 

Residual Interests

On November 29, 2001, the Federal Deposit

Insurance Corporation (FDIC), the Federal

Reserve Board (FRB), the Office of the

Comptroller of the Currency (OCC), and the

Office of Thrift Supervision (OTS) issued a final

rule that changes their regulatory capital standards

to address the treatment of recourse obligations,

residual interests, and direct credit substitutes that

expose banks, bank holding companies, and thrifts

to credit risk. The final rule treats recourse obligations and direct credit substitutes more consistently than the agencies' current risk-based capital

standards do; introduces a credit ratings-based

approach to assigning risk weights within a securitization; and requires that, for certain types of

residual interests that are not deducted from a

bank's Tier 1 capital, capital must be set aside on a

*Lynne Montgomery is a senior financial analyst in the FDIC’s Division of
 

Insurance and Research.
 

Reference sources: American Banker (AB), BNA’s Banking Report (BBR), and
 

Federal Register (FR).
 

dollar-for-dollar basis. The new rule also limits

the concentration of credit-enhancing interestonly strips-a form of residual interest that is

commonly used in association with securitization

of an asset pool-to 25 percent of an institution's

Tier 1 capital. The excess will be deducted from

Tier 1 capital. The risk-based capital treatment

for recourse obligations, direct credit substitutes,

and qualifying residual interests is determined by

the application of a ratings-based methodology.

For all three of these instruments, a risk weight

ranging from 20 percent to 200 percent is

assigned, depending on the particular instrument's

ratings grade. The instruments rated one category

below investment grade (BB) are subject to a 200

percent risk weight, whereas those rated AAA or

AA receive a more favorable 20 percent risk

weight. The new rule also allows an institution to

use either its own internal risk-rating system or a

qualifying rating-agency program to determine the

capital requirements for some unrated recourse

obligations and direct credit substitutes. The new

rule was effective for covered transactions that

settled on or after January 1, 2002. BBR, 10/29/01,

pp. 672-73; FR, Vol. 66, No. 230, pp. 59613-67; PR-82-2001,

FDIC, 11/29/01.

2003, VOLUME 15, NO. 1 36 
FDIC Banking Review 

Final Rules on Regulatory Capital Treatment of

Nonfinancial Equity Investments

On January 8, 2002, the FDIC, the FRB, and the

OCC adopted final rules governing the regulatory

capital treatment of equity investments in nonfinancial companies held by banks, bank holding

companies, and financial holding companies. The

new capital requirements apply symmetrically to

equity investments that banks and their holding

companies make in nonfinancial companies under

the legal authorities specified in the final rules.

Among others, these authorities include the merchant banking authority granted by the GrammLeach-Bliley Act and the authority to invest in

small business investment companies (SBICs)

granted by the Small Business Investment Act.

Covered equity investments are subject to a series

of marginal Tier 1 capital charges, with the size of

the charge increasing as the organization's level of

concentration in equity investments increases.

The highest marginal charge requires a 25 percent

deduction from Tier 1 capital for covered investments that aggregate more than 25 percent of an

organization's Tier 1 capital. Equity investments

through SBICs will be exempt from the new

charges to the extent that the aggregate investments do not exceed 15 percent of the banking

organization's Tier 1 capital. The new charges do

not apply to individual investments made by banking organizations before March 13, 2000; also

exempted from coverage are grandfathered investments made by state banks under Section 24(f) of

the Federal Deposit Insurance Act. The final

rules became effective on April 1, 2002. PR-2-2002,

FDIC, 1/8/02.

FDIC's Expanded Powers to Review 

Problem Banks

A new policy approved by the federal bank and

thrift regulators on January 29, 2002, gives the

FDIC more authority to conduct special examinations of troubled banks and thrift institutions that

are viewed as a threat to the deposit insurance

funds. The policy allows the FDIC to examinewithout the express permission or invitation of the

bank's primary federal supervisor-any institution

that has a CAMELS composite rating of 3, 4, or 5

or is considered undercapitalized. Previously, if

the FDIC wanted to examine a problem bank that

it did not supervise, it had to get permission to do

so from the bank's regulator. The policy also

allows the FDIC to examine an institution that

exhibits "material deteriorating conditions or

other adverse developments regardless of current

rating," provided the agency gets the primary

supervisor's permission. The policy also includes a

new exam program that creates a dedicated FDIC

examiner for each of the eight largest banking

companies. The dedicated examiner must be

informed of all developments in the supervision of

the banks and will be the main FDIC contact for

the supervisory personnel of an institution's primary regulator. AB, 1/30/02; BBR, 2/4/02, pp. 189-90.

Publication of Agencies' Guide to Privacy of

Information

On February 6, 2002, several federal agencies

released a guide to help consumers make informed

choices about whether to allow their personal

financial information to be shared. "Privacy

Choices for Your Personal Financial Information"

guides consumers through the choices they face as

a result of the privacy provisions of the GrammLeach-Bliley Act of 1999. Federal privacy laws

give consumers the right to prevent, or "opt out"

of, the sharing of their personal financial information. The guide explains the privacy notices that

consumers receive from their banks and other

financial companies, the choices consumers face,

and consumers' right to opt out of information

sharing. The agencies that issued the guide

include the FDIC, the FRB, the OCC, the OTS,

the National Credit Union Administration, the

Commodity Futures Trading Commission, the

Federal Trade Commission, and the Securities and

Exchange Commission. The guide can be

accessed at www.consumer.gov or at any of the

federal agencies' Web sites. PR-13-2002, FDIC, 2/6/02.

37 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

Common Form for Charter and Federal Deposit

Insurance Applications

On March 11, 2002, the FDIC, the OCC, and the

OTS issued a uniform application form, the

"Interagency Charter and Federal Deposit

Insurance Application," which will be used by

financial institutions to apply for a national bank

or federal savings association charter or for federal

deposit insurance. The new form is part of an

ongoing effort by the regulatory agencies to simplify procedures, eliminate duplicative or outdated

policies, and reduce the regulatory burden on

financial institutions. PR-31-2002, FDIC, 3/11/02.

Lower Risk Weighting for Claims on 

Securities Firms

On April 9, 2002, the FDIC, the FRB, the OCC,

and the OTS issued a final rule amending their

risk-based capital standards for banks, bank holding companies, and savings associations to reduce

the risk weight applied to claims on, or guaranteed

by, qualifying securities firms. The final rule

reduces the risk weight applied to certain claims

on qualifying securities firms from 100 percent to

20 percent. In addition, consistent with the existing rules of the FRB and the OCC, the FDIC and

the OTS amended their risk-based capital standards to permit a zero percent risk weight for certain claims on qualifying securities firms that are

collateralized by cash or by securities issued or

guaranteed by the U.S. government or by the central governments of the members of the

Organization for Economic Cooperation and

Development (OECD). The rule became effective

on July 1, 2002. PR-FRB, 4/9/02.

Guidance on Risks of Parallel-Owned Banking

Organizations

On April 23, 2002, the FDIC, the FRB, the OCC,

and the OTS issued guidance on the potential

risks of parallel-owned banking organizations.

The guidance defines parallel ownership as direct

or indirect control of both a U.S. depository institution and a foreign bank by one person or by a

group of persons who are closely associated in

their business dealings. The definition specifically

excludes organizations controlled by companies

that are governed by the Bank Holding Company

Act or the Savings and Loan Holding Company

Act. The guidance describes various risks that

may be increased because of the structure of parallel-owned banking organizations (for example,

engaging in transactions that prefer the foreign

bank member of the group over the U.S. depository institution). The agencies will address these

risks by coordinating their supervision of the U.S.

banking operations of parallel-owned banking

organizations and by enhancing communication

and cooperation with foreign bank supervisors.

PR-46-2002, FDIC, 4/23/02; BBR, 4/29/02, p. 732.

Rule on Branches Used for Deposit Production

On June 6, 2002, the FDIC, the FRB, and the

OCC issued a joint final rule banning banks from

establishing or acquiring a branch outside their

home states primarily for the purpose of generating deposits. The rule implements a provision on

out-of-state deposit production that was contained

in Section 106 of the Gramm-Leach-Bliley Act of

1999 (GLBA). The Riegle-Neal Interstate

Banking and Branching Efficiency Act of 1994

had prohibited any bank from establishing or

acquiring a branch outside of its home state for

the purpose of generating deposits, and provided

guidelines for determining whether such bank is

reasonably helping to meet the credit needs of the

communities served by the branch. Section 106 of

the GLBA expanded the deposit prohibition to

cover any branch of a bank that is controlled by

an out-of-state holding company. The new rule

became effective October 1, 2002. PR-FRB, 6/5/02;

BBR, 6/17/02, p. 1054.

Federal Deposit Insurance Corporation 

Swearing-in of Powell as Chairman

On August 29, 2001, Donald E. Powell was sworn

in as the 18th Chairman of the FDIC. He began

his banking career in 1963 with First Federal

Savings & Loan of Amarillo, Amarillo, Texas.

2003, VOLUME 15, NO. 1 38 
 

 

 

FDIC Banking Review 

Before joining the FDIC, Mr. Powell was president

and CEO of The First National Bank of Amarillo,

Amarillo, Texas. PR-57-2001, FDIC, 8/29/01.

Appointment of Reich as Vice Chairman

On November 15, 2002, John M. Reich was

appointed Vice Chairman of the FDIC Board of

Directors. Mr. Reich had been a Director of the

FDIC since January 16, 2001, and served as

Acting Chairman between Chairman Donna

Tanoue's resignation in July 2001 and Chairman

Powell's assumption of office in August 2001.

Before joining the FDIC, Mr. Reich served for 12

years on the Washington staff of former U.S.

Senator Connie Mack (R-FL), initially as deputy

chief of staff and later as chief of staff. Mr. Reich

also spent 23 years as a community banker in

Illinois and Florida, the last ten years of which

were as president and CEO of the National Bank

of Sarasota, Sarasota, Florida. PR-122-2002, FDIC,

11/15/02.

Web Page for Database of Unclaimed Funds

The FDIC launched a Web site that allows users

to search a database of unclaimed funds from

failed financial institutions that were closed by a

regulatory agency between January 1, 1989, and

June 28, 1993, and for which the FDIC was

appointed receiver. The FDIC holds unclaimed

funds in two ways: as unclaimed insured deposits

of active receiverships and as undeliverable dividend checks. An active receivership is a receivership that the FDIC is still managing-disposing of

the assets and administering the liabilities. A dividend check is considered undeliverable when the

depositor's address is incorrect or the check has

never been cashed. The Web site provides depositors of failed institutions who have not already

claimed their funds, or whose dividend checks

have been returned to the FDIC as undeliverable,

an opportunity to claim their funds. Detailed

instructions for searching the database and claiming funds can be found at

http://www2.fdic.gov/funds/index.asp. PR-56-2001,

FDIC, 8/27/01.

Report on Underwriting Practices-April and

October 2002

The April 2002 issue of the FDIC's semiannual

Report on Underwriting Practices reported slight

increases in the risks associated with current

underwriting practices, loan portfolios, and loan

administration at FDIC-supervised banks. The

frequency of risky practices in all major lending

categories rose at least slightly, and in two of the

categories-construction lending and commercial

real estate lending-increases in the frequency of

risky underwriting practices were noteworthy. The

April report includes surveys from 1,149 FDICsupervised banks that were examined during the

six months ending March 31, 2002. This survey

of loan underwriting practices is aimed at providing an early warning of potential problems in

underwriting practices at FDIC-supervised, statechartered nonmember banks. The focus of the

survey is threefold: material changes in underwriting standards for new loans, degree of risk in

current practices, and specific aspects of the

underwriting standards for new loans. Report on

Underwriting Practices, FDIC, April 2002.

In the October 2002 issue of the report, the most

noteworthy changes reported in underwriting

practices were a slight increase in the credit risk of

banks' loan portfolios and increases in the riskiness of agricultural and construction lending. The

October 2002 issue includes surveys from 1,201

FDIC-supervised banks that were examined during the six months April 1, 2002, through

September 30, 2002. Report on Underwriting Practices,

FDIC, October 2002. 

Real Estate Survey-July 2002

The July 2002 issue of the Survey of Real Estate

Trends reported continued deterioration in the

nation's real estate markets during the first six

months of 2002, although the rate of deterioration

was slower than in the last six months of 2001.

Reports of market imbalance strongly emphasized

oversupply in the commercial markets, while tight

conditions continued to be noted in residential

markets. The proportion of respondents who

39 2003, VOLUME 15, NO. 1 
 

FDIC Banking Review 

described single-family markets as tight-33 percent-was double the figure for the previous sixmonth period, and both sales volumes and home

sale prices were reported to be higher than six

months earlier. Weakness in local office markets

continued to be widespread, with 65 percent of

respondents reporting a worsening in office market

conditions. However, a majority reported a

decrease in speculative office construction.

Reports of oversupply in retail and industrial markets were somewhat more frequent than they had

been six months earlier: in retail markets, excess

supply was observed by 68 percent of respondents,

up from 65 percent in the previous survey; in

industrial markets, excess supply was observed by

64 percent of respondents, up from 58 percent.

The July report summarized the opinions of 252

survey respondents, who consisted of FDIC senior

examiners and asset managers as well as bank

examiners of the Federal Reserve Banks, the

OCC, and the OTS. Survey of Real Estate Trends, FDIC,

July 2002.

Insurance Funds' Financial Results for 

First Three Quarters of 2002

The FDIC reported that the Bank Insurance Fund

(BIF) had comprehensive income (net income

plus/minus current-period unrealized gains/losses

on available-for-sale securities) of $944 million for

the nine months ending September 30, 2002,

compared with income of $859 million for the

same period in 2001. Although net income

declined by $341 million compared with the previous year's amount, unrealized gains on availablefor-sale securities increased by $426 million. The

decline in net income resulted primarily from

lower earnings on U.S. Treasury obligations and

higher estimated losses for anticipated bank failures and litigation activity. As of September 30,

2002, the BIF balance was approximately $31.4

billion, up from $30.4 billion at year-end 2001.

The BIF reserve ratio fell from 1.26 percent at

December 31, 2001, to 1.23 percent (as amended)

at March 31, 2002, as a result of a $75 billion

increase in estimated insured deposits. The

deposit growth resulted primarily from a reporting

change in the quarterly Call Reports that provide

the source data for estimating insured deposits.

This was the first time since 1995 that the reserve

ratio fell below the mandated designated reserve

ratio of 1.25 percent. The reserve ratio climbed

back up to 1.26 percent at June 30, 2002; the

increase resulted from an increase in the BIF balance of $490 million in the second quarter of

2002, and a $3 billion decrease in the estimated

insured deposits. 

The Savings Association Insurance Fund (SAIF)

reported comprehensive income of $651 million

for the first three quarters of 2002, compared with

$56 million for the same period in 2001. The

increase in comprehensive income was due primarily to higher estimated losses in 2001 for actual

and expected thrift failures. The SAIF's fund balance as of September 30, 2002, was $11.6 billion,

up from $10.9 billion at year-end 2001. The SAIF

reserve ratio held steady at 1.36 percent between

December 31, 2001, and March 31, 2002, but

then increased to 1.38 percent at June 30, 2002.

PR-113-2002, FDIC, 10/25/02.

Bank Failures

Superior Bank, FSB, Hinsdale, Illinois, was closed

by the OTS on July 27, 2001, and the FDIC was

named conservator. Superior Bank had total

assets of approximately $2.3 billion and total

deposits of approximately $1.6 billion. The FDIC

Board of Directors decided the least-cost alternative was to organize a new institution that would

operate under FDIC control. The insured deposits

and substantially all the assets of Superior Bank

were transferred to Superior Federal, FSB (New

Superior), which was chartered on July 27, 2001.

As part of this transaction, the FDIC provided a

$1.5 billion line of credit to New Superior to support continued banking operations. The FDIC

also hired savings bank executive John D.

Broderick to serve as president and chief executive

officer of New Superior while the FDIC searched

for a buyer. On October 31, 2001, the FDIC

Board of Directors approved the sale of the

branches and deposits of New Superior to Charter

One Bank, FSB, Cleveland, Ohio. Charter One

agreed to pay the FDIC a premium of $52.4 mil2003, VOLUME 15, NO. 1 40 
FDIC Banking Review 

lion to assume $1.1 billion of the deposits and $45

million of the assets held by the FDIC in conservatorship. On December 10, 2001, the FDIC and

the OTS reached a resolution with the holding

companies of Superior Bank on all matters arising

out of the operation and failure of Superior.

Under the agreement, the holding companies and

their owners admitted no liability and agreed to

pay the FDIC $460 million and other consideration. On February 15, 2002, the FDIC sold the

servicing rights and the residual interests in $3.7

billion of securitized subprime mortgage loans to a

subsidiary of Bear Stearns & Company for $471

million. Superior Bank was the first failure of an

institution insured by the SAIF-but the third

failure of an FDIC-insured institution-in 2001.

PR-52-2001, FDIC, 7/27/01; PR-55-2001, FDIC, 8/20/01;
 

BBR, 8/27/01, p. 336; PR-78-2001, FDIC, 10/31/01; 

AB, 2/27/02. 

Sinclair National Bank, Gravette, Arkansas, was

closed by the OCC on September 7, 2001, and the

FDIC was appointed receiver. Sinclair National

had total assets of approximately $30.7 million

and total deposits of approximately $25.7 million.

Delta Trust & Bank, Parkdale, Arkansas, paid the

FDIC a premium of $551,000 for the right to

assume the insured deposits and to purchase $4.9

million of Sinclair National's assets. The FDIC

retained the remaining $25.8 million in assets for

later disposition. Sinclair National was the third

failure of a BIF-insured bank-and the fourth failure of an FDIC-insured institution-in 2001. 

PR-63-2001, FDIC, 9/7/01.

On January 11, 2002, the OCC closed Hamilton

Bank NA, Miami, Florida, and the FDIC was

named receiver. Hamilton Bank had total assets

of approximately $1.3 billion and total deposits of

approximately $1.2 billion. Israel Discount Bank

of New York, New York, New York, assumed all

the insured deposits of three branches, and those

branches remain open. Israel Discount Bank also

assumed the insured transaction deposits (checking, savings, and money market accounts) of

Hamiliton's other six branches, but the branches

were closed. Israel Discount Bank also acquired a

nominal amount of Hamilton's assets, which mainly consisted of cash. Hamilton was the first failure

of a BIF-insured bank in 2002 and the first bank

failure in Florida since September 1999. PR-3-2002,

FDIC, 1/11/02.

The Texas Banking Commissioner on January 18,

2002, closed Bank of Sierra Blanca, Sierra Blanca,

Texas, and the FDIC was named receiver. Bank of

Sierra Blanca had total assets of approximately

$10.8 million and total deposits of approximately

$9.8 million. The Security State Bank of Pecos,

Pecos, Texas, paid a premium of $218,000 to

assume the insured deposits and to purchase $3.5

million of Bank of Sierra Blanca's assets. The

FDIC retained the remaining assets for later disposition. This was the second failure of a BIFinsured institution in 2002 and the first bank

failure in Texas since 1999. PR-5-2002, FDIC, 1/18/02.

On February 1, 2002, the Ohio Superintendent of

Financial Institutions closed The Oakwood

Deposit Bank Company, Oakwood, Ohio, and the

FDIC was named receiver. The Oakwood Deposit

Bank had total assets of approximately $72.3 million and total deposits of approximately $60 million. The State Bank and Trust Company,

Defiance, Ohio, paid a premium of $4.1 million to

receive the failed bank's insured deposits and to

purchase certain assets, including cash, securities

at market value, loans fully secured by deposits,

and performing and not adversely classified loans.

The FDIC retained the remaining assets for later

disposition. This was the third failure of a BIFinsured institution in 2002. PR-11-2002, FDIC, 2/4/02.

The OCC closed NextBank NA, Phoenix,

Arizona, on February 7, 2002, and the FDIC was

appointed receiver. The OCC acted after finding

that the bank was operating in an unsafe and

unsound manner and had experienced a substantial dissipation of assets and earnings. The OCC

also found that there was no reasonable prospect

for the bank to become adequately capitalized

without federal assistance. NextBank, an

Internet-only bank, solicited only certificates of

deposit of $100,000 or more and had no checking

or savings accounts. NextBank had total assets of

$700 million and total deposits of $554 million, of

41 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

which $29.4 million exceeded the federal deposit

insurance limit. Since there were no bids for

NextBank's deposits, the FDIC approved a payoff

of the insured deposits. NextBank was the fourth

failure of a BIF-insured institution in 2002 and the

first bank failure in Arizona since 1992. PR-16-2002,

FDIC, 2/7/02.

On March 1, 2002, the OCC closed Net First

National Bank, Boca Raton, Florida, and the

FDIC was named receiver. Net First had assets of

approximately $35 million and total deposits of

$31 million. Bank Leumi USA, New York, New

York, paid the FDIC a premium of $4.55 million

to assume the insured deposits of Net First and to

purchase approximately $6 million of the failed

bank's assets. The FDIC retained the remaining

assets for later disposition. Net First was the fifth

failure of a BIF-insured institution-and the second failure in Florida-in 2002. PR-26-2002, FDIC,

3/1/02.

New Century Bank, Shelby Township, Michigan,

was closed on March 28, 2002, by the Michigan

Commissioner of the Office of Financial and

Insurance Services, and the FDIC was named

receiver. New Century had total assets of $19 million and total deposits of $18 million. The FDIC

approved a payoff of the insured deposits, since

there were no bids for the bank's deposits. New

Century was the sixth failure of a BIF-insured

institution in 2002 and the first bank failure in

Michigan since 1998. PR-38-2002, FDIC, 3/28/02. 

On June 26, 2002, the Connecticut Bank of

Commerce, Stamford, Connecticut, was closed by

the Banking Commissioner of the Connecticut

Department of Banking, and the FDIC was named

receiver. The Connecticut Bank of Commerce

had assets of approximately $399 million and

insured deposits of $213 million. Hudson United

Bank, Mahwah, New Jersey, paid the FDIC a premium of $17.3 million to assume the insured

deposits and to purchase certain assets of the

failed bank. The FDIC retained the remaining

assets for later disposition. Connecticut Bank of

Commerce was the seventh failure of a BIFinsured institution in 2002. PR-74-2002, FDIC,

6/26/02; PR-80-2002, FDIC, 6/28/02.

Universal Federal Savings Bank, Chicago, Illinois,

was closed by the OTS on June 27, 2002, and the

FDIC was named receiver. Universal Federal had

total assets of approximately $52 million and

insured deposits of $40 million. Chicago

Community Bank, Chicago, Illinois, paid a premium of approximately $3.1 million to purchase the

failed bank's insured deposits and certain assets.

The FDIC retained the remaining assets for later

disposition. Universal Federal was the first failure

of a SAIF-insured institution-but the eighth failure of an FDIC-insured institution-in 2002.

PR-76-2002, FDIC, 6/27/02; PR-81-2002, FDIC, 6/28/02.

AmTrade International Bank of Georgia, Atlanta,

Georgia, was closed on September 30, 2002, by

Georgia's Commissioner of Banking and Finance,

and the FDIC was named receiver. AmTrade was

chartered as an international trade bank; its

administrative offices were in Atlanta, and its sole

deposit-production office was in Miami, Florida.

The bank had approximately $12 million in total

assets and $10.2 million in total deposits. After

receiving no bids for the bank's deposits, the FDIC

approved a payoff of the insured deposits.

AmTrade was the ninth failure of an FDICinsured institution in 2002 and the first in Georgia

since 2000. PR-100-2002, FDIC, 9/30/02.

On November 8, 2002, the FDIC closed Bank of

Alamo, Alamo, Tennessee, and took possession of

the bank in its capacity as receiver. Bank of

Alamo had total assets of approximately $69.4

million and total deposits of $55.3 million. An

estimated $6 million of deposits in approximately

200 accounts exceeded the federal deposit insurance limit. After receiving no acceptable bids for

the bank's deposits, the FDIC approved a payoff of

the insured deposits. This was the tenth failure of

an FDIC-insured institution in 2002. PR-120-2002,

FDIC, 11/8/02.

The Farmers Bank & Trust of Cheneyville,

Cheneyville, Louisiana, was closed by the

Louisiana Commissioner of Financial Institutions

on December 17, 2002, and the FDIC was named

receiver. Farmers Bank had total assets of approximately $37 million and total deposits of $33 million, including approximately $1.8 million in

2003, VOLUME 15, NO. 1 42 
 

 

 

 

 

FDIC Banking Review 

deposits that exceeded the federal deposit insurance limit. Sabine State Bank and Trust

Company, Many, Louisiana, assumed the insured

deposits of Farmers Bank, paying the FDIC a premium of 1.35 percent of these deposits, and purchased approximately $2.2 million of the failed

bank's assets. Farmers Bank was the eleventh and

final failure of an FDIC-insured institution in

2002 and the first bank failure in Louisiana since

1997. PR-131-2002, FDIC, 12/17/02.

Federal Reserve Board 

New Board Term for Ferguson

On July 26, 2001, Roger W. Ferguson, Jr., began a

new term as Vice Chairman of the Board of

Governors of the Federal Reserve System. Dr.

Ferguson joined the Board of Governors on

November 5, 1997, when he was appointed to fill

an unexpired term that ended in January 2000.

President Clinton renominated him for a full term

in 2000, but the Senate Banking Committee

delayed all confirmation hearings until after the

presidential election. On March 5, 2001,

President Bush renominated Dr. Ferguson, and the

Senate confirmed him on July 19, 2001. Before

joining the Board of Governors, Dr. Ferguson had

been a partner at the New York-based international management-consulting firm of McKinsey

& Company. His new Board of Governors term

expires January 31, 2014. PR-FRB, 7/26/01; BBR,

7/30/01, p. 186.

Four New Members of Board of Governors

Between December 2001 and August 2002, Susan

Schmidt Bies, Mark W. Olson, Donald L. Kohn,

and Ben S. Bernanke joined the Board of

Governors.

Dr. Bies was sworn in on December 7, 2001, filling

the seat previously held by Susan M. Phillips.

Before becoming a member of the board, Dr. Bies

had served in various positions at First Tennessee

National Corporation, Memphis, Tennessee. Her

two most recent positions there (from 1995 to

2001) were executive vice president for risk management and auditor. Dr. Bies's term on the Board

of Governors expires January 31, 2012.

Mr. Olson was also sworn in on December 7,

2001, and filled the seat that had been vacated by

the resignation of Alice M. Rivlin in July 1999.

Mr. Olson served as president and CEO of

Security State Bank, Fergus Falls, Minnesota, from

1976 to 1988 and was president of the American

Bankers Association from 1986 to 1987. More

recently, he was a partner at Ernst and Young LLP,

where he started the firm's financial services regulatory practice and managed it until retiring from

Ernst and Young in 1999. From 2000 to 2001 he

served as staff director of the Securities

Subcommittee of the Senate Banking, Housing,

and Urban Affairs Committee. His board term

expires January 31, 2010.

Dr. Kohn took office on August 5, 2002, filling the

seat vacated by Laurence H. Meyer, whose term

expired in January 2002. Dr. Kohn began his

career with the Federal Reserve System in 1970,

when he joined the Federal Reserve Bank of

Kansas City as a financial economist. He was subsequently Associate Director of the Division of

Research and Statistics (1981-1983), Deputy Staff

Director for Monetary and Financial Policy

(1983-1987), Director of the Division of

Monetary Affairs (1987-2001), Secretary of the

Federal Open Market Committee (1987-2002),

and Adviser to the Board for Monetary Policy

(2001-2002). Dr. Kohn's term on the Board of

Governors expires January 31, 2016.

Dr. Bernanke also joined the Board of Governors

on August 5, 2002, filling the seat vacated when

Edward W. Kelley, Jr., resigned on December 31,

2001. Dr. Bernanke had been a professor of economics and public affairs at Princeton University

since 1985 and in 1996 was appointed the Howard

Harrison and Gabrielle Snyder Beck Professor of

Economics and Public Affairs as well as chair of

the Economics Department. He had been a visiting scholar at three Federal Reserve Banks:

Philadelphia (1987-1989), Boston (1989-1990),

and New York (1990-1991, 1994-1996). He

served on the Academic Advisory Panel at the

Federal Reserve Bank of New York from 1990 to

43 2003, VOLUME 15, NO. 1 
 

FDIC Banking Review 

2002. Dr. Bernanke's term on the Board of

Governors expires January 31, 2004.

www.federalreserve.gov.

State Member Banks' Ownership of Certain

Financial Subsidiaries

On August 13, 2001, the FRB adopted a final rule

that permits state-chartered banks that are members of the Federal Reserve System to own subsidiaries that engage in certain financial activities,

such as general insurance, securities, and travel

agency sales. However, bank subsidiaries are

barred from real estate investment and development, insurance underwriting, and merchant

banking. The rule outlines the criteria that banks

must meet to own financial subsidiaries, including

sufficient capitalization and strong management.

The rule, which implements the financial subsidiaries feature of the 1999 Gramm-Leach-Bliley

Act, is intended to establish parity between state

member banks and national banks, which were

given similar powers in 2000 by the OCC.

AB, 8/14/01; BBR, 8/27/01, pp. 309-10.

Revisions to Regulation K-International

Banking Operations

Effective November 20, 2001, the FRB implemented comprehensive revisions to Regulation K,

which governs international banking operations.

The final rule expands permissible activities

abroad for U.S. banking organizations and reduces

the associated regulatory burden. The rule also

streamlines the application and notice processes

for foreign banks operating in the United States,

thus reducing their regulatory burden. In addition, the rule implements recent statutory changes

authorizing a bank to invest up to 20 percent of

capital and surplus in Edge corporations, expands

permissible foreign activities of U.S. banking

organizations, liberalizes provisions regarding the

qualification of foreign banking organizations for

exemptions from the nonbanking prohibitions of

Section 4 of the Bank Holding Company Act, and

implements provisions of the Riegle-Neal

Interstate Banking and Branching Efficiency Act

of 1994 that affect foreign banks. PR-FRB, 10/17/01.

Payments System Risk 

The FRB announced on December 11, 2001, that

it had revised its Policy Statement on Payments

System Risk. The revised policy incorporates,

with minor modifications, the FRB's May 30,

2001, interim policy. The revised policy allows

certain depository institutions to pledge collateral

to the Federal Reserve in order to access additional daylight overdraft capacity above their net debit

caps. The policy modifies the net debit cap calculation for U.S. branches and agencies of foreign

banks. The policy also modifies the time when

electronic check presentments are posted to

depository institutions' Federal Reserve accounts

for purposes of measuring daylight overdrafts. In

addition, the Federal Reserve retains the $50 million limit on the value of book-entry securities

transfers. The revised policy statement became

effective December 10, 2001, with the following

exceptions: (1) revisions to the criteria used to

determine the U.S. capital equivalency measure

for foreign banking organizations took effect on

February 21, 2002, and (2) the modification of the

time for posting electronic check presentments to

depository institutions' Federal Reserve accounts

took effect on April 1, 2002. PR-FRB, 12/11/01.

Amendments to Regulation Z-Truth in Lending

On December 11, 2001, the Federal Reserve

Board approved a final rule that amends

Regulation Z (Truth in Lending) to curb predatory

lending. The amendments broaden the scope of

loans subject to the protections of the Home

Ownership and Equity Protection Act (HOEPA)

of 1994 by adjusting the price triggers that determine coverage under the act. The rate-based trigger is lowered by 2 percentage points for first-lien

loans, and the fee-based trigger is revised to

include optional insurance premiums and costs of

similar credit protection products paid at closing.

Certain acts and practices in connection with

home-secured loans are prohibited; for example,

creditors are restricted from engaging in repeated

refinancings of their own HOEPA loans over a

short period when the transactions are not in the

borrower's interest. The final rule strengthens

HOEPA's prohibition against extending credit

2003, VOLUME 15, NO. 1 44 
FDIC Banking Review 

without regard to a consumer's repayment ability

by requiring creditors to document and verify

income for HOEPA-covered loans. Disclosures

received by consumers before closing for HOEPAcovered loans include the total amount of money

borrowed and whether that amount includes

optional credit insurance or costs of similar products paid at closing. Compliance with the amendments became mandatory on October 1, 2002.

PR-FRB, 12/12/01.

Increase in �ome Mortgage Disclosure Act's

Threshold for Exemption from Reporting

The FRB raised from $31 million to $32 million

the asset-size exemption threshold for depository

institutions that are required to report data under

the Home Mortgage Disclosure Act (HMDA). In

2002, depository institutions with assets of $32

million or less became exempt from reporting data

on their housing-related lending activities. The

final rule amends Regulation C, which implements

HMDA. HMDA requires most depository institutions to collect, report, and disclose data about

applications for, and originations and purchases of,

home mortgage loans, home improvement loans,

and refinancings. Data reported include the type,

purpose, and amount of the loan; the race or

national origin, gender, and income of the loan

applicant; and the location of the property. The

purposes of HMDA include helping regulators (1)

determine whether financial institutions are serving the housing needs of their communities, and

(2) enforce fair lending regulations. The asset

level that releases institutions from reporting data

under HMDA is adjusted each year on the basis of

changes in inflation as measured by the Consumer

Price Index for Urban Wage Earners and Clerical

Workers. On December 24, 2002, the FRB

announced that the asset-size exemption threshold would remain at $32 million throughout 2003.

PR-FRB, 12/19/01; PR-FRB, 12/24/02.

Amendments to Regulation C-�ome Mortgage

Disclosure Act

On February 15, 2002, the FRB published amendments to Regulation C, which implements the

Home Mortgage Disclosure Act (HMDA). The

amendments require lenders to disclose pricing

data on higher-cost loans, expand the number of

nondepository institutions subject to HMDA's

reporting requirements, and revise certain regulatory definitions. The amendments also require

that a nondepository lender report under HMDA

if the lender originated $25 million or more in

home purchase loans, including refinancings, in

the prior year. The amendments also require the

reporting of some home equity credit lines.

On June 21, 2002, the FRB published additional

amendments requiring lenders to report the lien

status of applications and originated loans and, in

applications taken by telephone, to ask applicants

their ethnicity, race, and gender. Compliance with

the amendment requiring lenders to ask telephone

applicants for monitoring information is mandatory for applications taken on or after January 1,

2003. Compliance with the other amendments

will be mandatory for data collected on or after

January 1, 2004. BBR, 1/28/02, pp. 121-22; PR-FRB,

5/2/02; PR-FRB, 6/21/02.

Final Regulation W

On October 31, 2002, the FRB approved a final

Regulation W that comprehensively implements

Sections 23A and 23B of the Federal Reserve Act,

unifying in one public document the FRB's interpretations of those sections. Sections 23A and

23B and Regulation W restrict (1) loans by a

depository institution to its affiliates, (2) asset purchases by a depository institution from its affiliates, and (3) other transactions between a

depository institution and its affiliates. The purpose of Sections 23A and 23B and Regulation W

is to limit both a bank's risk of loss in transactions

with affiliates and its ability to transfer to its affiliates the benefits arising from its access to the federal insurance safety net. The final regulation

becomes effective on April 1, 2003. PR-FRB,

11/27/02.

Amended Regulation A

On October 31, 2002, the FRB approved a final

rule amending Regulation A by revising the

45 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

Federal Reserve System's discount window programs, which provide credit to help depository

institutions meet temporary liquidity needs. The

rule replaces adjustment credit, which is extended

at a below-market rate, with a new type of discount window credit called primary credit, which

is broadly similar to credit programs offered by

many other major central banks. Primary credit is

available for very short terms as a backup source

of liquidity to depository institutions that are in

sound financial condition. Federal Reserve Banks

extend primary credit at a rate above the federal

funds rate, thus eliminating the incentive for institutions to borrow for the purpose of exploiting the

positive spread of money market rates over the

discount rate. The Reserve Banks establish the

primary credit rate at least every two weeks, subject to review by, and determination of, the Board

of Governors, through the same procedure used to

set the adjustment credit rate. The final rule

includes a provision that could facilitate a reduction in the primary credit rate in a financial emergency. The final rule also establishes a secondary

credit program that is available in appropriate circumstances to depository institutions that do not

qualify for primary credit. The FRB anticipates

that Federal Reserve Banks will establish the secondary credit rate at a level 50 basis points above

the primary credit rate. PR-FRB, 10/31/02.

Survey on Bank Lending Practices

In its October 2002 issue of the quarterly Senior

Loan Officer Opinion Survey on Bank Lending

Practices, the FRB reported that during the threemonth period ending October 2002, both domestic and foreign banks had continued a trend of

stricter business lending practices. Although the

percentage of domestic banks reporting tightened

standards for commercial and industrial (C&I)

loans to large and middle-market firms during the

period edged down to 20 percent from 22 percent

in the July 2002 survey, the percentage that tightened their standards for business loans to small

firms during the period jumped from 6 percent in

the previous survey period to 20 percent. Both

foreign and domestic institutions indicated that

the most important reason for tightening standards and terms on C&I loans was a less-favorable

economic outlook. Domestic and foreign institutions reported that the demand for C&I and commercial real estate loans weakened between the

July and October surveys. Domestic banks attributed the decline in C&I loans to reduced demand

from creditworthy borrowers, whereas foreign

institutions reported that their own tighter lending

standards played a role in the decline. For the

report, the Federal Reserve surveyed loan officers

from 55 large domestic banks and 20 foreign banking institutions. The survey focused on changes

during the preceding three months in the supply

of and demand for bank loans to households and

businesses. Senior Loan Officer Opinion Survey on Bank

Lending Practices, FRB, October 2002.

Office of the Comptroller of the Currency 

Change in Deposits Required for Branches of

Foreign Banks

On March 4, 2002, the OCC implemented moreflexible capital equivalency requirements for federal branches of foreign banks to reduce costs for

institutions that present low levels of risk. Under

the existing law, federal branches of foreign banks

were required to maintain in trust accounts at

other banks a capital equivalency deposit (CED)

equal to 5 percent of their liabilities. The CED

funds, which are intended to serve as a cushion

against losses, could not be withdrawn without

OCC permission. The OCC implemented two

changes to this law: (1) low-risk branches are permitted to withdraw excess deposits without seeking prior OCC approval, and (2) the liability base

over which the CEDs are calculated was redefined

to exclude liabilities booked on a federal branch's

international banking facility. However, several

safeguards were maintained under the new

approach. The OCC will continue to require a

CED agreement with a foreign bank, and the

assets in the account must be free from liens or

claims other than those of the OCC. The OCC

will continue to have rights to the CED in the

event the federal branch goes into receivership.

In addition, every federal branch must continue to

2003, VOLUME 15, NO. 1 46 
FDIC Banking Review 

maintain a CED of at least $1 million, even if that

amount is more than 5 percent of liabilities.

NR 2002-16, OCC, 3/4/02.

Rule Amending Regulations on Banking and

Electronic Technologies

On May 17, 2002, the OCC published in the

Federal Register a final rule that gives national

banks guidance on several aspects of their authority to engage in electronic commerce. One provision of the new rule permits national banks to act

in the capacity of a "finder" between providers

and buyers of financial and nonfinancial products

and services that are fostered by new technologies

such as the Internet. The rule offers guidance to

national banks seeking to conduct new activities

electronically by describing the factors the OCC

uses to determine if an electronic activity is part of

the business of banking. The rule also clarifies

that a national bank's electronic activity will not

be exempt from general OCC guidance applicable

to the underlying activity conducted through conventional means. And when national banks share

electronic space (such as Web pages or Web sites)

with other businesses, the rule requires that the

bank take reasonable steps to clearly, conspicuously, and understandably distinguish between products and services it offers and those the other

business offers. NR 2002-44, OCC, 5/16/02; BBR,

5/20/02, pp. 863-64.

Survey of Credit Underwriting Practices

The OCC's eighth annual Survey of Credit

Underwriting Practices reported that underwriting

standards for commercial and retail loans tightened during the 12-month period ending March

31, 2002. For the second consecutive year, the

majority of surveyed banks tightened commercial

loan underwriting standards (67 percent of banks

in 2002, compared with 55 percent in 2001). The

survey found that most banks made no change to

retail underwriting standards, and those that did

primarily tightened standards (39 percent of

banks). The 2002 survey covered the 62 largest

national banks with an aggregate loan portfolio of

$2 trillion, which represents approximately 90 percent of all outstanding loans in national banks.

The survey, which is completed by OCC senior

examiners, consists of a series of questions about

16 types of commercial and retail lending. The

questions focus on the direction of lending standards and the level of inherent risk in the portfolios and products of the banks examined. 2002

Survey of Credit Underwriting Practices, OCC, June 2002.

Office of Thrift Supervision 

Swearing-in of Gilleran as New Director

James E. Gilleran was sworn in as director of the

OTS on December 7, 2001. He served as chairman and chief executive officer of the Bank of San

Francisco from 1994 to 2000 and as superintendent of the California State Banking Department

from 1989 to 1994. He also served as chairman of

the Conference of State Bank Supervisors (CSBS)

from 1993 to 1994 and as a member of the CSBS's

Bankers Advisory Council until 2000. Mr.

Gilleran replaces outgoing director Ellen Seidman.

OTS 01-83, 12/7/01.

Updated �andbook on Trust and Asset

Management Services

On August 27, 2001, the OTS published a revised

version of the Trust and Asset Management

�andbook, which helps agency examiners plan and

perform exams of thrift institutions' trust and asset

management services. The revision highlights the

OTS's emphasis on a risk-focused approach to

examinations. The revised handbook contains a

comprehensive review of the products and services, laws and regulations, and risks and fiduciary

duties applicable to savings associations that

engage in trust and asset management activities.

BBR, 9/10/01, p. 377.

Revised Lending Rule

On December 20, 2001, the OTS issued a final

rule that (1) allows federally chartered thrift institutions to expand the availability of low-cost credit to small business and agricultural borrowers, and

47 2003, VOLUME 15, NO. 1 
 

FDIC Banking Review 

(2) provides additional flexibility for thrifts that

invest in their communities. For loans meeting

the definition under the Home Owners' Loan Act

of lending to small businesses, the rule increases

the dollar limit from $1 million to $2 million; for

loans to farms, the limit is raised from $500,000 to

$2 million. The rule provides an additional measure of flexibility for loans to certain individuals

who use the loan proceeds for their small enterprises, as long as the proceeds are used for commercial, corporate, business, or agricultural

purposes. The rule also permits thrifts to increase

the amount of their total capital that they may

commit to community development investments;

the new limit is the greater of 1 percent of total

capital or $250,000. The rule also provides thrifts

with an enhanced ability to invest in state and

local government obligations and gives them

unlimited authority to invest in such obligations.

The rule allows both real property and personal

property to be the primary source of security for

real estate loans. The final rule became effective

January 1, 2002. BBR, 12/24/01, p. 1010.

Adjusted Capital Requirements for 

I- to 4-Family Mortgages

On May 10, 2002, the OTS adjusted its capital

requirements for one- to four-family residential

first mortgage loans. Under the new requirements, a one- to four-family loan will qualify for

50 percent risk-weight capital treatment if the

loan is underwritten in accordance with prudent

underwriting standards, including standards in the

Interagency Guidelines for Real Estate Lending.

The OTS eliminated the requirement that a loanto-value ratio of 80 percent or less is necessary for

a loan to qualify for the 50 percent risk weight. In

addition, the rule eliminates the requirement that

a thrift institution deduct from capital the portion

of a land loan or nonresidential construction loan

exceeding an 80 percent loan-to-value ratio.

OTS 02-26, 5/9/02.

Amendment to Alternative Mortgage Transaction

Parity Act

The Alternative Mortgage Transaction Parity Act,

adopted in 1982, grants certain state-chartered

housing creditors parity with federally chartered

lenders when making alternative mortgages. An

alternative mortgage is a loan with payment features-such as variable rates or balloon payments-that vary from conventional fixed-rate,

fixed-term mortgage loans. On September 26,

2002, the OTS announced a final rule that

amended its regulations under the Parity Act to

make state-chartered housing lenders subject to

state, not OTS, rules governing prepayment penalties and late fees. The final rule becomes effective

July 1, 2003. BBR, 9/30/02, p. 528; OTS 02-44, 12/6/02.

Federal Housing Finance Board 

Appointment of Korsmo as Chairman

On November 29, 2001, John T. Korsmo was

named a director of the Federal Housing Finance

Board, and on December 21, 2001, he was designated the board's chairman. Mr. Korsmo replaces

J. Timothy O'Neill, who had served as chairman

since June 18, 2001, and remains a director. In

1998 Mr. Korsmo founded Korsmo Consulting

Services, Inc., a health-care, political, and sports

marketing consulting firm in Fargo, North Dakota.

He served as policy and legislative director for

North Dakota governor Ed Schafer in 1996 and

1997, and chaired the North Dakota Republican

Party from 1993 to 1995. Until 1996, Mr. Korsmo

was president and owner of Cass County Abstract

Company, in Fargo, and founder and president of

Red River Title Services in Moorehead,

Minnesota. He was also founder and, from 1983

to 1992, president of the Title Company of Fargo,

the first independent escrow and closing company

in North Dakota and northwestern Minnesota.

Dow Jones Newswires, 12/19/01.

Changes to Affordable �ousing Program

On September 12, 2002, the Federal Housing

Finance Board (FHFB) approved changes to the

Affordable Housing Program, giving Federal Home

Loan Banks additional tools to help first-time

homebuyers. (The Affordable Housing Program

provides direct subsidies or loans at subsidized

rates to the Federal Home Loan Bank [FHLB]

2003, VOLUME 15, NO. 1 48 
 

FDIC Banking Review 

System's member institutions to finance the purchase, construction, or rehabilitation of affordable

housing units. The FHLB System contributes to

the program the greater of 10 percent of net earnings or $100 million per year.) Previous FHFB

regulations authorized the Federal Home Loan

Banks each year to allocate for homeownership

set-aside programs the greater of $3 million or 25

percent of their Affordable Housing Program contribution. The new rule allows each Federal

Home Loan Bank to set aside specifically for firsttime homebuyers an additional amount of up to

the greater of $1.5 million or 10 percent of its

annual Affordable Housing Program amount. The

final rule also increases the maximum subsidy limit

per household to $15,000 for homeownership setaside programs in general. F�FB 02-42, 9/12/02.

National Credit Union Administration 

Appointment of Dollar as Chairman

On September 13, 2001, President Bush appointed

National Credit Union Administration (NCUA)

board member Dennis Dollar as the agency's

chairman. Mr. Dollar had served on the NCUA

board since October 1997 and had been the acting

chairman since February 2001. From 1992 to

1997, he served as the president and CEO of

Gulfport VA Federal Credit Union. From 1976 to

1984 he served two terms in the Mississippi House

of Representatives. His term on the NCUA board

expires in 2003. NR-NCUA, 09/17/01.

Appointment of Two New Board Members

On March 22, 2002, Deborah Matz and JoAnn

Johnson were confirmed as members of the

NCUA Board of Directors. Ms. Matz filled the

seat that had been held by Geoff Bacino until his

term expired on December 20, 2001. Ms. Johnson

filled the seat vacated by Yolanda Townsend

Wheat on December 21, 2001.

Ms. Matz had most recently been the executive

officer at the Liaison Office for North America of

the Food and Agriculture Organization (FAO) of

the United Nations. Before joining FAO, she

served in the U.S. Department of Agriculture

(1993-2001), where she held numerous high-level

positions, including deputy assistant secretary for

administration, chair of the loan resolution task

force, and chief of staff to the administrators of

the Farm Service Agency and the Farmers Home

Administration. Ms. Matz had also served nine

years as an economist with the Congressional Joint

Economic Committee.

Ms. Johnson was a member of the Iowa Senate at

the time of her appointment, having been elected

to that body in 1994. She chaired the Senate's

Ways and Means Committee from 1996 to 2000

and the Commerce Committee from 2000 until

resigning her seat to accept the NCUA board

position. NR-NCUA, 1/23/02.

Exemption of �ealthy Credit Unions from

Certain Regulations

In a final rule released on November 21, 2001, the

NCUA declared that credit unions with high net

worth and consistently strong supervisory ratings

are exempt from a range of federal regulations.

Credit unions that receive a composite safety and

soundness rating of 1 or 2 for two consecutive

examinations, have a net-worth ratio of 9 percent

or higher, and are well capitalized under the

NCUA's prompt corrective action regulations are

automatically exempt from rules that require quarterly stress-testing of certain securities and from

rules that limit how third parties handle investments. In addition, they need not obtain an

appraisal for a loan unless the loan amount is

$250,000 or higher. Other credit unions may also

be eligible for the exemption; however, they must

submit a formal application to the NCUA. The

new rule, referred to as "RegFlex," became effective March 1, 2002. BBR, 11/26/01, p. 867.

�Access-Across-America� Initiative

On February 25, 2002, Chairman Dollar unveiled

a program that focuses on creating economic

empowerment by providing access to credit unions

in neighborhoods and communities that lack

49 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

access to low-cost financial services. The program, labeled "Access Across America," is

designed to establish partnerships between the

NCUA and key federal departments and agencies

to counter the growing problem of predatory lending as well as to broaden the access of underserved

communities to affordable financial services. The

NCUA will support underserved areas by chartering new, community-oriented credit unions, particularly in growing Hispanic communities; developing faith-based and campus credit unions; and

championing the expansion of financial literacy

programs developed by local credit unions in communities across the United States. NR-NCUA,

2/25/02.

STATE LEGISLATION AND REGULATION
 

All States� New Rules on Collateral

New rules governing how banks perfect liens and

how borrowers file collateral statements took

effect (for most states on July 1, 2001) under a

revised Article 9 of the Uniform Commercial

Code (UCC). Article 9 of the UCC governs what

lenders can accept as collateral and how collateral

agreements must be documented. The revised

rules set parameters for using personal property as

collateral for a loan, and change the filing system

for financial statements that detail collateral.

Previously the financial statements were filed

where the collateral was located, which is often at

the local level. Under the new rules, all financial

statements have to be filed in just one place: the

secretary of state's office in the debtor's home

state. The new rules became effective for 46

states on July 1, 2001; Alabama, Florida, and

Mississippi delayed implementation until January

1, 2002, and Connecticut until October 1, 2002.

AB, 7/5/01.

California

Governor Gray Davis (D) signed bill A.B. 489 on

October 10, 2001, aimed at curbing predatory

lending practices by prohibiting licensed persons,

such as real estate brokers or mortgage lenders,

from engaging in specific acts that harm consumers. The new law is aimed at helping vulnerable people such as senior citizens, immigrants, and

low-income families by focusing on the serious

abuses practiced by the small minority of lenders

that engage in unfair or deceptive practices. The

new law prohibits repeated refinancings of mortgage loans in which lenders extract money for

points and fees but provide no benefit to homeowners and leave them worse off financially than

they were before the refinancings. In addition, the

law prohibits brokers and lenders from steering

borrowers toward loans with interest rates and

terms that are higher than those for which they

could qualify, and prohibits loans that the borrower would clearly not be able to repay. The law also

bans incorporating into a loan, to inflate the

amount of money being borrowed, points and fees

of more than 6 percent of the loan amount to be

financed. BBR, 10/15/01, p. 587.

Governor Davis also signed legislation on October

10, 2001, requiring credit card issuers to disclose

to cardholders in their monthly statements the

length of time it would take to pay off their balances if they made only the minimum monthly

payments. The new disclosure requirement took

effect July 1, 2002. BBR, 10/22/01, p. 636.

Colorado

Governor Bill Owens (R) signed H.B. 1259 on

June 7, 2002, prohibiting lenders from engaging in

certain practices on high-interest loans. The prohibited practices include the following: requiring

the entire balance of the loan to be paid just a few

years after the loan is issued, charging high fees for

early repayment of loans, and refinancing a loan

within one year (this prohibition applies only if

the refinancing is not in the borrower's interest).

BBR, 6/17/02, p. 1053. 

2003, VOLUME 15, NO. 1 50 
 

FDIC Banking Review 

Florida

On July 30, 2001, Governor Jeb Bush (R) signed a

bill regulating payday loans in Florida. The new

law, which became effective October 1, 2001, is

designed to prevent fees associated with payday

loans from escalating out of control. The law provides a backstop by limiting loans to $500, capping

fees at 10 percent of the loan, and allowing only

one payday loan at a time. The law also creates a

60-day grace period in which people who cannot

repay loans can seek credit counseling and devise

a repayment plan. �nig�t-Ridder/Tribune Business News,

7/31/01.

On April 22, 2002, Governor Bush signed into law

a bill (S.B. 2262) that prohibits door-to-door solicitations, the financing of points and fees exceeding

3 percent of a loan amount, and other predatory

mortgage lending practices. The Florida Home

Loan Protection Act became effective October 2,

2002. BBR, 4/29/02, p. 746.

Governor Bush signed into law H.B. 3-E merging

the comptroller and treasurer positions into one

chief financial officer position as head of a new

Department of Financial Services. The

Department of Financial Services consists of 13

divisions and offices, including the Office of

Financial Institutions and Securities Regulation,

which will regulate credit unions, banks, finance

companies, and the securities industry. The provisions related to the chief financial officer position

became effective January 7, 2003. BBR, 6/24/02, p.

1099.

Georgia

On April 22, 2002, Governor Roy E. Barnes (D)

signed a bill (H.B. 1361) that cracks down on the

lending practices of predatory lenders who cater to

the subprime residential housing market. The

Georgia Fair Lending Act sets up several triggers;

loans above a trigger will be considered high cost

and will automatically have certain restrictions.

The restrictions include no unreasonable prepayment penalties, no balloon payments, no negative

amortization, no penalty interest rates, no excessive advance payments, and no mandatory arbitration. The law also bans lenders from selling single-premium credit life insurance and prohibits

them from charging multiple late fees on a single

payment. The law became effective October 1,

2002. BBR, 4/29/02, p. 746.

Illinois

By signing H.B. 1089 on August 10, 2001, Illinois

Governor George Ryan (R) increased the basic

loan limit for a single entity from 20 percent of a

bank's unimpaired capital and surplus to 25 percent. The new law, known as Public Act 92-0336,

brings Illinois into conformity with lending limits

for national banks. BBR, 8/27/01, pp. 326-27.

Missouri

On June 27, 2002, Governor Bob Holden (D)

signed a bill (S.B. 884) that caps interest rates on

payday loans. Under the provisions of the new

act, payday loans must have a term of between 14

and 31 days. Although the act stipulates that

lenders may charge any simple interest or fees

agreed to by the borrower, it caps the total amount

of interest and fees at 75 percent of the initial

loan amount. In addition, the act limits to six the

number of times that a loan can be renewed and

requires borrowers to begin repaying the principal

of a loan before renewing it for the first time.

Borrowers are also prohibited from repaying a loan

with proceeds from another loan from the same

lender. BBR, 7/8/02, p. 59.

New �ork

On October 3, 2002, Governor George E. Pataki

(R) signed legislation to prohibit predatory lending

practices in the subprime mortgage lending market. The law prohibits the financing of certain

insurance products, restricts the use of balloon

payments, and limits the financing of excessive

points and fees. Under the law, a home loan is

deemed void if a court finds that the lender intentionally violated the law. The law grants borrowers an affirmative defense against foreclosure when

a loan has been made in violation of the law. It

also allows for a private right of action against a

51 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

lender within six years of the origination of a loan.

Other provisions of the law require greater disclosure to consumers; one such provision requires

that high-cost loans clearly state at the top of

mortgage documents that they are high-cost home

loans. BBR, 10/7/02, p. 551.

North Carolina

In North Carolina, where engaging in the business

of money transmission without a license is prohibited, a new law requires that businesses and individuals seeking to obtain a license must

demonstrate a certain level of financial worth,

post a surety bond, and pay an application fee.

The law also requires annual and quarterly reports

and license renewal fees, sets out specific requirements for the maintenance of records and a certificate of authority, and contains provisions

covering the change in control of a license.

Internet sites accessible to North Carolina residents are covered by the prohibitions. However,

banks, credit unions, savings and loan institutions,

government entities, and their contractors are

exempted from the provisions. The new law

became effective October 1, 2001. BBR, 10/29/01, 

p. 697.

Oregon

The National Association of Insurance Commissioners announced on April 30, 2002, that Oregon

state insurance regulators and the OTS had

signed an information-sharing agreement. The

agreement provides for the sharing of nonpublic

information on the financial solvency of insurance

companies and of any depository institutions the

companies own that fall within the jurisdiction of

the state insurance commissioner and the OTS.

The agreement covers insurance and thrift activities, as well as consumer complaints about the

entities involved. Oregon is the 45th state that

has signed a sharing agreement. OTS 02-24, 4/30/02.

RECENT ARTICLES AND STUDIES
 

A report issued by the Fannie Mae Foundation in

August 2001 says that one-fourth of all lowerincome families have no relationship with a bank,

savings institution, credit union, or other mainstream financial services provider. America's most

financially vulnerable households are turning

increasingly to high-cost alternative financial service providers-fringe lenders-to meet their financial service needs. Service fees charged by fringe

lenders typically are much higher than those

charged by mainstream financial service

providers. The report, entitled Financial Services

in Distressed Communities� Framing t�e Issue,

Finding Solutions, lists several reasons that many

lower-income and minority households use fringe

lenders, including a lack of physical proximity to

mainline financial institutions, a lack of understanding of or trust in financial institutions, and a

lack of basic consumer finance education. Dow

Jones Newswires, 8/2/01.

A pair of studies released on August 29, 2001,

conclude that banks that do business exclusively

over the Internet are having a hard time compared with those that have traditional branch

services. The first study, performed by Jupiter

Media Metrix, found that Internet traffic to

online-only banks fell 8 percent between July

2000 and July 2001. In contrast, the number of

visitors to banks with both branches and online

services, known as multichannel banks, climbed

111 percent during the same period. Jupiter analysts concluded that consumers prefer traditional

banking and are more likely to conduct online

banking with a financial services company that

offers easy access to customer service, nearby

automated teller machines, and nearby branches.

The second study, conducted by Maritz Research,

found that 47 percent of U.S. residents prefer

banking at their local branches to banking over

the Internet. This survey, which polled 1,005

2003, VOLUME 15, NO. 1 52 
 

 

FDIC Banking Review 

adults randomly selected from around the United preferred ATMs and only 4 percent preferred

States, also found that 18 percent of consumers banking over the Internet. BBR, 9/10/01, p. 361.

BANK AND THRIFT PERFORMANCE
 

First-Quarter 2002 Results for Commercial

Banks and Savings Institutions

FDIC-insured commercial banks earned $21.7 billion during the first quarter of 2002, up from

$19.8 billion in the first quarter of 2001. Key factors in the higher earnings were wider net interest

margins at large banks and slow growth in noninterest expenses. Banks' annualized return on

assets (ROA) was 1.33 percent in the first quarter,

up from 1.26 percent one year earlier. The number of commercial banks on the FDIC's "Problem

List" increased from 95 to 102 in the quarter, and

assets of "problem" banks rose from $36 billion to

$37 billion. Six insured commercial banks failed

in the first quarter of 2002.

FDIC BIF-insured mutual savings institutions

reported earnings of $3.6 billion in the first quarter of 2002, an increase of $715 million from the

first quarter of 2001. The industry's ROA for the

quarter was 1.12 percent, down from 1.18 percent

in the fourth quarter of 2001 but up from 0.95

percent one year earlier. There were 22 "problem"

thrifts, up slightly from 19 at year-end 2001; however, assets of "problem" thrifts increased dramatically during the first quarter, rising to $15.0 billion

from $3.7 billion in the previous quarter. No

thrifts failed during the first quarter of 2002. 

FDIC �uarterly Banking Profile, First �uarter 2002.

Second-Quarter 2002 Results for Commercial

Banks and Savings Institutions

Continued strength in consumer loan demand,

plus a favorable interest-rate environment, outweighed the negative effects of weakness in commercial loans for banks in the second quarter of

2002. Commercial banks' earnings rose to $23.4

billion in the second quarter, which is $1.7 billion

higher than in the previous quarter. Commercial

banks' average ROA was 1.41 percent in the second quarter of 2002, up from 1.33 percent in the

first quarter of 2002 and from 1.21 percent in the

second quarter of 2001. The number of commercial banks on the FDIC's "Problem List" increased

from 102 to 115 during the quarter, but assets of

"problem" banks declined from $37 billion to $36

billion. One bank failed during the second quarter.

FDIC BIF-insured mutual savings institutions,

benefiting from a favorable interest-rate environment and gains on sales of securities, earned $3.9

billion in the three months from April through

June 2002, which is $236 million higher than in

the previous quarter and $519 million higher than

one year earlier. The industry's ROA for the second quarter rose to 1.19 percent, up from 1.12

percent in the first quarter of 2002 and from 1.06

percent in the second quarter of 2001. The number of "problem" thrifts fell slightly from 22 to 21

during the quarter, and "problem" assets dropped

sharply from $15.0 billion to $3.8 billion. One

thrift failed and, with assistance, merged into a

commercial bank. FDIC �uarterly Banking Profile, Second

�uarter 2002.

Third-Quarter 2002 Results for Commercial

Banks and Savings Institutions

FDIC-insured commercial banks earned $23.3 billion during the third quarter of 2002, falling

slightly from $23.4 billion in the second quarter of

2002. Banks' average ROA was 1.37 percent in

the third quarter, down from 1.41 percent in the

second quarter but up from 1.17 percent in the

third quarter of 2001. The number of commercial

banks on the FDIC's "Problem List" increased

from 115 to 126 in the quarter, and assets of

"problem" banks rose from $36 billion to $38 billion. One commercial bank failed in the third

quarter of 2002.

53 2003, VOLUME 15, NO. 1 
FDIC Banking Review 

A favorable interest-rate environment helped

FDIC BIF-insured mutual savings institutions realize $1.9 billion in gains from sales of securities,

increasing industry earnings to just under $4.0 billion in the third quarter of 2002, up from $3.9 billion in the second quarter of 2002 and from $3.5

billion in the third quarter of 2001. The industry's

ROA for the quarter was 1.20 percent, up from

1.19 percent in the second quarter of 2002 and

from 1.08 percent one year earlier. The number of

"problem" thrifts declined from 21 to 20 during

the quarter, but assets of these institutions rose

slightly from $3.8 billion to $3.9 billion. No thrifts

failed during the quarter. FDIC �uarterly Banking

Profile, T�ird �uarter 2002.

INTERNATIONAL DEVELOPMENTS
 

Canada

On June 14, 2001, the Canadian Parliament

approved new framework legislation for Canada's

financial services sector, clearing the way for

increased competition in the industry. Bill C-8,

An Act to Establish the Financial Consumer

Agency of Canada and to Amend Certain Acts in

Relation to Financial Institutions, was published

by the Department of Finance on October 24,

2001. The legislation, which consists of 75 regulations, is expected to promote efficiency and

growth in the financial services sector, foster international competitiveness and domestic competition, empower and protect consumers of financial

services, and improve the regulatory environment.

Key elements of the legislation include permission

for financial institutions to engage in a broader

range of investments in specific areas of electronic

commerce, either through holding companies or

through traditional parent-subsidiary structures;

permission for financial institutions operating in

Canada to establish regulated, nonoperating holding companies that are subject to less regulatory

burden than chartered banks; creation of the

Financial Consumer Agency of Canada to enforce

consumer-oriented provisions of federal financial

institution statutes; and provisions to ensure that

the government's new entry regime for foreign

banks (permitting foreign banks to directly operate

branches in Canada) is consistent with the regulatory framework for domestic banks. Of the 75

regulations, 37 relate to the new framework's

restructuring of the permitted investment regime,

18 relate to the new holding company regime for

financial institutions, 6 relate to the creation of

the new Financial Consumer Agency of Canada, 6

relate to changes to the foreign bank regime, and

the remaining 8 are aimed at various other policy

objectives. BBR� 6/25/01, pp. 1081-83; 10/29/01, pp.

704-6; 11/12/01, pp. 792-93; 12/3/01, pp. 911-13.

China

China's securities regulators issued new regulations

allowing commercial banks to directly trade stocks

for clients beginning May 1, 2002. Additionally,

beginning August 1, 2002, all banks, both Chinese

and foreign, became eligible to buy and sell foreign

exchange to individuals, ending the People's Bank

of China's monopoly in the foreign exchange market. BBR� 4/29/02, pp. 758-59; 8/5/02, p. 252.

Japan

Prime Minister Junichiro Koizumi's cabinet on

November 12, 2002, established an office for

speeding up the disposal of nonperforming loans.

The Industry Reconstruction and Employment

Strategy Headquarters, which is directed by Mr.

Koizumi, was formed as an equity-issuing organization that is fully owned by the governmental

Deposit Insurance Corporation (DIC). Its funds

will be drawn from the DIC's financial rehabilitation fund or on a new account to be formed. 

BBR, 11/18/02, pp. 824-25.

2003, VOLUME 15, NO. 1 54 
FDIC Banking Review 

On November 29, 2002, the Japanese government

introduced a nonperforming loan workout schedule that features stricter bank asset inspections,

launches a bank inspection team, and injects

emergency central bank loans and public funds

into nonviable banks. The workout schedule also

highlights stricter implementation of prompt corrective measures on banks whose capital has been

exhausted; the measures would require such banks

to restore stable bank management within one

year. In addition, such banks would be put under

control of the government and the Bank of Japan

as institutions that require "special assistance."

BBR, 12/2/02, p. 900.

55 2003, VOLUME 15, NO. 1