Banking Review 

2005 VOLUME 17, NO. 3 

China’s Opening to the World: What Does It Mean for 

U.S. Banks? (page 1) 

by Valentine V. Craig 

China has agreed to open its financial system to full foreign competition in December 2006. What 

does this financial opening mean for foreign banks? This article examines in detail the abundant 

opportunities and significant risks of entry into the Chinese market for U.S. banks. 

Overview of Recent Developments in the Credit Card Industry 

(page 23) 

by Douglas Akers, Jay Golter, Brian Lamm, and Martha Solt 

Recent events that may change the dynamics of the credit card industry are described and analyzed. 

A Moving-Average Formula for Calculating Deposit Insurance 

Assessments (page 37) 

by Panos Konstas 

This article examines the level and volatility of the assessment rates that would have been imposed if 

the current assessment policy had been in effect when the FDIC first began operations in 1934, and 

proposes an alternative approach for setting deposit insurance assessment rates that uses a movingaverage formula. This approach would smooth the extremes in the high assessment rates required 

under the current policy, thus helping the banking industry through cyclical fluctuations. 

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. 

Chairman Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

and Research 

Deputy Director Donald Inscoe 

Managing Editor Jack Reidhill 

Editorial Committee Christine E. Blair 

Valentine V. Craig 

Rose M. Kushmeider 

Publication Manager Geri Bonebrake 

China’s Opening to the World: 

What Does It Mean for U.S. Banks? 

by Valentine V. Craig* 

China has agreed to open its financial system to 

full foreign competition in December 2006 in 

accordance with its commitments to the World 

Trade Organization (WTO). In regard to banking, 

it has committed to remove all geographic, client, 

and nonprudential restrictions on foreign banks. 

What does this financial opening mean for foreign banks? This article examines in detail the 

opportunities and risks of entry into the Chinese 

market for U.S. banks. 

China, with 1.3 billion people, is a huge market, 

and it has been growing rapidly since the early 

1980s with no end in sight. This growth has produced abundant opportunities in China for financial services providers. The article begins with a 

review of recent statistics on Chinese growth and 

prosperity. It then appraises the competitive 

landscape for U. S. banks in China, examining 

the Chinese capital markets, the official Chinese 

banks, the informal Chinese banks, and foreign 

banks currently operating in China. The article 

then looks at the specific opportunities opening 

up in China in retail, commercial and investment 

banking. 

Doing business in China is not without risk. 

There are economic, political and demographic 

trouble spots in the economy that could affect 

businesses operating in China. The article examines these risks. It discusses fears of an overheating market, possible protectionism by those 

countries to which it exports its goods, rising economic inequality in the country, and China’s rapidly aging population. It then proceeds to look at 

the risks arising from an uncertain regulatory 

environment and a large unwieldy government 

bureaucracy. Corporate governance is generally 

not good, and the article reviews problems with 

corruption and lack of transparency in Chinese 

businesses, focusing particularly on Chinese 

banks. It then appraises the systems for ensuring 

a safe return of capital, concentrating on the adequacy of China’s bankruptcy laws, the enforcement of contracts and legal judgments, the 

adequacy of its credit infrastructure, the availability of crucial personnel, and the government’s 

commitment to open competition. 

The article ends with a summary of the analysis 

and concluding remarks. 

* Valentine V. Craig is a Chartered Financial Analyst in the Division of Insurance and Research of the FDIC. The author would like to thank Alicia Amiel 

in the FDIC library for her assistance in the writing of this article. 

FDIC BANKING REVIEW 1 2005, VOLUME 17, NO. 3 
China’s Opening to the World: What Does It Mean for U.S. Banks? 

An Overview of China’s Economy and 

Financial System 

China’s economy has grown tremendously over 

the past 20 years, as recent economic statistics 

make clear. This has created a demand for capital 

by private businesses in China, which the official 

domestic providers of capital—the Chinese capital markets and Chinese banks—beset with problems and focused on state-owned businesses, have 

not been able to satisfy. However, the government 

has been working to make the markets and banks 

more efficient and competitive and to combat 

fraud within them, and has made some progress. 

Additionally, many of the illegal “gray market” 

banks are currently a competitive force, and foreign banks have doubled their asset size in China 

over the past several years. 

Recent Economic Statistics 

Since the beginning of China’s open door policy 

in 1978, it is estimated that per capita income has 

increased seven times; 400 million people have 

risen from extreme poverty; and a middle class of 

approximately 100 million people has developed. 

The Economist credits China with “probably the 

most dramatic burst of wealth creation in human 

history.”1 Recent economic statistics reveal just 

how tremendous China’s economic growth has 

been.2 

China’s gross domestic product (GDP) reportedly 

grew 9.5 percent in 2004, following 9.3 percent 

(revised) growth in 2003.3 The growth in these 

two years followed average annual growth in the 

1980s of 9.3 percent, and between 1991 and 2003 

of 9.7 percent. Industrial capacity grew strongly 

in 2004, with industrial businesses’ value-added 

increasing 11.4 percent over the previous year. 

The sale of consumer goods increased 13.3 percent. Exports were up 35.4 percent and imports 

up 36 percent, with the nation reporting a trade 

surplus of U.S. $32 billion for 2004. Furthermore, 

the WTO reports that China replaced Japan as 

the world’s third-largest exporter in 2004.4 

Although many of the Chinese people are poor, 

their financial situation is improving. Real per 

capita growth rates of disposable income for both 

urban and rural households in 2004 were the 

highest they have been since 1997: 7.7 percent 

for urban households and 6.8 percent for rural 

households.5 And as mentioned, approximately 

100 million Chinese are considered middle class 

and middle income. The urban unemployment 

rate is a low 4.2 percent—0.1 percent less than in 

2003. While inflation has increased (it increased 

3.9 percent in 2004, following a 1.2 percent 

increase in 2003), it is quite moderate given the 

tremendous growth of the economy. Additionally, 

the Chinese people are great savers, saving over 

40 percent of GDP. Reported savings of households increased over 15 percent in 2004. 

Capital Markets 

There are two stock exchanges in mainland 

China—the Shanghai and Shenzhen exchanges. 

They are generally considered undeveloped and 

corrupt. However, the government has been 

working to improve the corporate governance of 

these exchanges. There is a large government 

bond market, but the corporate bond market is 

insignificant. 

1 The Economist (2004d), 11.
 

2 Some analysts believe that growth has not been as great as officially reported because of suspect data. Official Chinese economic statistics, although
 

improving, are generally considered unreliable. The World Bank estimates
 

that China overstated its growth between 1978 and 1995 by 1.2 percent a
 

year; the OECD believes the overstatement was 3.8 percent between 1986
 

through 1995 (Lardy 2002). Unlike most developed countries, China does not
 

seasonally adjust its statistics, and the lack of seasonal adjustment can distort recent activity. Other analysts question the accuracy of the raw data
 

themselves. Business Report (2004) suggests that economic figures should
 

be viewed as “highly manipulated political statements” rather than hard numbers. Even trade statistics are not considered reliable. The New York Times
 

(2004) reports that some companies exaggerate exports to claim tax credits,
 

and others underreport imports to avoid customs duties. Despite all these
 

qualifications, however, there is general agreement that China’s economy has
 

grown tremendously over the past two decades, although less than officially
 

reported.
 

3 National Bureau of Statistics of China (2005).
 

4World Trade Organization (2005).
 

5World Bank (2005).
 

2005, VOLUME 17, NO. 3 2 FDIC BANKING REVIEW 
China’s Opening to the World: What Does It Mean for U.S. Banks? 

Stock Exchanges. The two stock exchanges were 

formed in 1991 and 1992 primarily to fund the 

government’s bailout of failing state-owned enterprises. Currently there are approximately 1,300 

predominately state-owned enterprises listed on 

the two exchanges with a combined total market 

value of $400 billion. In most countries, companies with the best prospects typically launch 

IPOs, but as the Chinese government—rather 

than independent underwriters—is responsible for 

deciding which companies to list in China, until 

very recently, these companies were—with a few 

exceptions—failing state-owned enterprises. 

To maintain control of these state-owned assets, 

the government issued two general types of securities—state-owned shares or legal-person shares, 

which are not allowed to trade, and tradable 

shares. Approximately two-thirds of the shares of 

listed firms are the former. With so many shares 

not permitted to trade, the market is very illiquid. 

Fear of the state-owned shares being dumped on 

the market has reportedly kept share prices low 

despite the booming economy and has discouraged the development of derivative and corporate 

bond markets. 

The exchanges offer A-shares and B-shares. Ashares are denominated in renminbi (or yuan), 

the Chinese currency, and are available for sale 

only to Chinese nationals; B-shares are foreign 

currency denominated, and foreigners are allowed 

to purchase them. 

Domestic companies can also list in Hong Kong 

(“H” shares or “Red Chips”). This exchange and 

the companies it lists are generally considered 

better than those on the mainland. However, the 

Hong Kong exchange has some governance issues, 

according to shareholder activists.6 

Some domestic companies also list overseas. The 

best-performing state-owned enterprises and private companies, in addition to listing in Hong 

Kong, list overseas on the New York, NASDAQ, 

or Singapore exchanges. 

The mainland Chinese stock markets have had 

serious problems with corruption, cronyism and 

lack of transparency. Euromoney describes these 

markets as “mired in corruption, dominated by 

moribund companies and manipulated by government and speculators alike.”7 Corruption extends 

beyond the exchanges to include listed companies. The China Securities Regulatory Commission (CSRC), which regulates the securities 

market, reported in 2004 that 10 percent of its 

listed companies had doctored their books. 

Improvements are being made: the CSRC has 

recently taken steps to improve the functioning of 

the two exchanges. It is in the process of ending 

the differential treatment of its A-shares and Bshares. Additionally, foreigners can now apply to 

buy the state-owned shares, albeit with significant 

restrictions, and more private companies are 

being allowed to list. On May 1, 2005, the government announced a pilot program under which 

it would begin to sell a small number of stateowned shares in a controlled way to avoid any 

disturbance in the markets. The expectation is 

that this will alleviate the depressed value of the 

listings and make the market more liquid. 

The CSRC is also tackling corruption. It is 

investigating related-party transactions to stop 

the prevalent practice of shifting assets from listed 

companies to their unlisted state-owned parents. 

It plans to examine all related-party transactions 

where the price of assets bought or sold deviates 

more than 20 percent from an independent 

appraisal. Additionally, the CSRC has been 

monitoring brokerages for malfeasance and in 

2004 it seized control of the fifth largest broker 

for corruption and mismanagement.8 

Bond Markets. The government bond market is 

large. But although a great number of government bonds are issued,9 the four largest Chinese 

banks typically buy 60 to 70 percent of any treasury issue, effectively setting the bond’s price. 

Doubt about the true value of the debt has 

6 Wehrfritz (2005).
 

7 Leahy (2004), 92.
 

8 Economist (2004b), 19.
 

9 At the end of 2004 there were approximately $127 billion in treasury bills
 

outstanding, and $268 billion in one- to ten-year notes and bonds outstanding
 

(The Standard [2004]).
 

FDIC BANKING REVIEW 3 2005, VOLUME 17, NO. 3 
China’s Opening to the World: What Does It Mean for U.S. Banks? 

encouraged a buy-and-hold market, and this illiquidity deprives companies of favored instruments 

for hedging short-term risk. 

The corporate bond market is tiny. 

Chinese Banks 

The Chinese banking system is very large because 

of its preeminent role in financial intermediation, 

the large economy, the high level of household 

savings, and restrictions on overseas investments.10 It is predominantly state-owned. Given 

the very weak capital markets in China, the 

banking system provides an estimated 80 percent 

to 90-plus percent of all business funding. In 

early 2005, total bank loans to governmentowned and private businesses represented approximately 160 percent of Chinese GDP, up from 120 

percent in 2000.11 Consumer loans, a relatively 

new development in China, constituted approximately 10 percent of all outstanding bank loans 

in early 2005. Of these consumer loans, mortgages accounted for approximately 90 percent.12 

There are four big state-owned commercial banks, 

established originally to fund large state-owned 

enterprises. There are, in addition, 12 joint-stock 

commercial banks (JSCBs) owned by local governments, domestic investors, or foreign investors; 

an estimated 35,000 rural credit cooperatives; 

three policy banks, which focus specifically on 

economic development; over 100 city commercial 

banks, which are restricted to doing business in 

their base city only; and numerous rural commercial banks, urban credit cooperatives, and finance 

companies. 

The big four banks are the Industrial & Commercial Bank of China (ICBC), China Construction 

Bank (CCB), Bank of China, and Agricultural 

Bank of China. At the end of 2001, collectively 

they employed 1.4 million people and had 

116,000 branches across China. Although the 

big four banks represent the largest banking bloc 

in China, with almost two-thirds of total deposits 

in September 2003, the JSCBs have been taking 

market share from them. In September 2003, the 

share of deposits held by the big four had declined 

to 64.9 percent from 68.3 percent in March 2002, 

whereas the share held by the JSCBs had 

increased to 14.7 percent from 12 percent over 

the same period.13 

The rural credit cooperatives accounted for 

approximately 12 percent of deposits in September 2003. These cooperatives are responsible for 

providing credit to small factories, farms, and 

households in smaller cities and rural areas. The 

government-owned policy banks (China Export 

and Import Bank, China Development Bank, and 

Agricultural Development Bank of China), the 

city commercial banks, foreign banks, rural commercial banks, urban credit cooperatives, and 

finance companies collectively accounted for the 

remaining (approximately) 8 percent of deposits 

in September 2003. 

The country’s central bank, the People’s Bank of 

China, is in charge of monetary policy. One of its 

powers is to set interest rates on deposits and 

loans. The China Bank Regulatory Commission 

(CBRC), established in April 2003, regulates and 

supervises all banks. 

Problems with the Banks. The original mission 

of Chinese banks was to act as a governmentdirected funding source for state-owned enterprises. The banks continue to lend primarily to these 

dying state-owned businesses, ignoring the growing vibrant private businesses in their midst. The 

big four state-owned banks in particular were used 

by the Chinese government as instruments to 

implement government development policy. 

They had little or no discretion as to borrowers or 

loan terms. Borrowers were approved by the government, which set identical loan rates for every 

borrower regardless of risk. These conditions did 

not support a market-oriented lending approach: 

10 Prasad (2004). 

11 Business Week (2005). 

12 The Economist (2005f). 

13 Ibid. 

2005, VOLUME 17, NO. 3 4 FDIC BANKING REVIEW 
China’s Opening to the World: What Does It Mean for U.S. Banks? 

credit analysis and risk management, for instance, 

were unnecessary and not performed. 

The political interference, along with corruption 

and lack of modern management skills, has resulted in high levels of nonperforming loans in Chinese banks. (This is covered in greater detail in 

the section below entitled “A Look at the Risks.”) 

Standard and Poor’s (S&P) estimated in September 2003 that approximately 45 percent of bank 

loans were bad. In 2005, on the basis of substantial government assistance to the banking industry, it lowered its estimate to approximately 31 

percent, or approximately $700 billion in bad 

loans.14 

Other analysts are less optimistic and believe that 

the banks made a substantial number of additional bad loans through early 2004, before a government crackdown on lending began. For instance, 

bank lending increased 56 percent in 2003 over 

the previous year, with much of this new lending 

directed to funding state-owned businesses and 

infrastructure improvements at the government’s 

behest. Banks also started aggressive lending to 

consumers at this time. Consumer loans now 

constitute 10 percent of outstanding bank loans. 

While it is too soon to estimate the full extent of 

new bad loans made during this time, the state 

National Audit Office warned in June 2004 that 

it was beginning to see widespread consumer loan 

problems. Auto loans are of particular concern. 

Volkswagen of China reported that 5 percent of 

auto loans in Beijing are in default. Other reports 

suggest that approximately 50 percent of car loans 

are overdue.15 

Official government figures for nonperforming 

loans are lower than the figures from other 

sources. The government estimates nonperforming loans at the end of 2004 at approximately 13 

percent of total loans. 

Recent Banking Reform. The Chinese government is trying to resolve the banks’ financial 

problems before national treatment is afforded to 

foreign banks in December 2006. The government’s approach is multifaceted: it has given the 

banks more discretion in their lending decisions; 

has tried to help the banks maintain their deposit 

base against the inroads of “gray-market” banking; 

has provided massive cash injections to rid the 

banks of bad loans; is working to improve corporate governance at the banks, including clamping 

down on corruption within the banks; and is trying to attract foreign investment to the banks, 

hoping that foreign involvement will spur local 

banks to acquire Western management practices, 

expertise, and capital. 

Greater discretion in lending decisions was 

recently granted to introduce banks to the concept of risk-based lending. In January 2004, the 

CBRC permitted banks to charge risky borrowers 

up to 70 percent over the benchmark lending 

rate. Previously they had been allowed to charge 

a maximum rate of up to 30 percent over the 

standard rate, and before that they had not been 

allowed to differentiate at all between borrowers 

in setting rates. 

Additionally, to help the “official” banks maintain their deposit base in the face of the substantially higher rates on deposits being offered by the 

“gray-market” banks (see below), in October 2004 

the central bank raised interest rates on one-year 

loans and on deposits by 25 basis points.16 

The government has also been pressing the banks 

to deal with billions in bad debt before full foreign competition begins. In the late-1990s, the 

government tried—unsuccessfully—to resolve the 

banks’ bad loan problem. In 1998 the government infused $32 billion into the banks. In 1999 

it purchased $170 billion in bad loans (at book 

value), which it then transferred for disposal to 

asset management companies created for this purpose. 

14 As a means of comparison, at the height of the U.S. savings and loan crisis
 

of the 1980s, nonperforming loans (defined most broadly) of U. S. thrifts never
 

reached 5 percent of total loans of U.S. thrifts.
 

15 The Economist (2005f), 73.
 

16 However, this very small movement in rates is not considered likely to affect
 

the deposit drain from the official banks to gray-market banks.
 

FDIC BANKING REVIEW 5 2005, VOLUME 17, NO. 3 
China’s Opening to the World: What Does It Mean for U.S. Banks? 

The CBRC is also working to improve corporate 

governance at the banks, with particular emphasis 

on uncovering and preventing corruption. (Corruption is widespread at the banks, and is discussed in greater detail in a later section). The 

CBRC issued new regulations in early 2005 

requiring banks to monitor senior management 

and board members through internal monitoring 

and independent external auditors and to establish internationally accepted risk management 

controls. To deal with widespread rural bank 

fraud, the CBRC is planning to restructure and 

consolidate the 35,000 rural credit cooperatives 

into a more manageable 2,000 institutions by 

2007.17 The CBRC has also begun to publicly 

report corruption uncovered at the banks. 

Finally, the government has been encouraging 

foreign banks to take minority positions in Chinese banks. To make the big four banks more 

attractive to foreign investors, the government 

bailed out two of them in December 2003 and a 

third bank the following year. Bailed out were 

the Bank of China, which the government plans 

to list in Hong Kong, and CCB, which the government plans to list in New York and Hong 

Kong. The two banks together were estimated to 

be more than $65 billion in debt; each received a 

direct infusion of $22.5 billion to bring its capital 

above the minimum set by the Bank for International Settlements and to lower its nonperforming 

loans. The government then made a $15 billion 

capital infusion into ICBC (the nation’s biggest 

bank, with 20,000 branch offices and 400,000 

employees),18 intending to list it in 2006. The 

remaining big-four banks, Agricultural Bank of 

China, and a dozen or so smaller banks are also 

expected to list their shares eventually. It is 

expected that listing will encourage foreign ownership in the banks. 

“Gray-Market” Banks. The gray-market banks 

are informal or sometimes well-organized, groups 

of lenders/investors. These informal banks reportedly provide much of the lending to small private 

sector businesses that do not have the political 

connections to borrow from the state-owned 

banks.19 They may consist of only a few individuals—family or friends of the borrower—with a 

little money to invest, or they can be large sophisticated lending cooperatives organized by rich 

entrepreneurs in search of higher yields. Annual 

interest rates on loans made by gray-market banks 

range from 8 to 20 percent, providing returns to 

investors substantially above the 2.25 percent 

official bank deposit rate. Consequently, the graymarket banks compete with the state-owned 

banks for deposits.20 

Some of these informal banks are quite large and 

highly efficient, competitive lenders, providing 

millions of dollars in structured financing to private businesses. Some of them reportedly borrow 

the money for their lending from the big four 

banks and then re-lend it to private borrowers at 

the higher rates.21 Defaults are rare due to the 

personal nature of the lending. Although illegal 

(organizing a gray-market bank is a capital 

offense), they are widespread and are generally 

tolerated by the government. In fact, they are so 

widespread that the CBRC has reportedly begun 

to informally monitor prevailing gray-market 

lending rates.22 The government has also bailed 

them out on occasion when they have failed. 

Foreign Banks23 

At the end of 2004, there were 62 foreign banks 

with over 200 branches operating in China with 

restricted licenses.24 Many of these banks had 

also invested in joint ventures with Chinese 

banks. In April 2005, foreign banks accounted 

17 BNA’s Banking Report (2004).
 

18 New York Times (2005).
 

19 Bradsher (2004). 


20 Real interest rates on deposits at the official banks are negative because
 

of low interest rates (raised from 2 percent to 2.25 percent in October 2004) 

and inflation of 3.9 percent in 2004. [Bradsher (2004].
 

21 Business Week (2004).
 

22 Ibid.
 

23 In reporting on the activity of individual foreign banks in China, the author
 

relies upon publicly available information—for the most part, news reports or
 

bank press releases. The activities of some very active foreign banks may be
 

overlooked and others overstated depending upon the extent of public coverage of their activities. 


24 Foreign banks additionally had established over 200 representative offices
 

in China by mid-2004.
 

2005, VOLUME 17, NO. 3 6 FDIC BANKING REVIEW 
 

China’s Opening to the World: What Does It Mean for U.S. Banks? 

for approximately 3 percent of total assets in the 

banking system, more than twice the 1.3 percent 

of total assets these banks held in September 

2003.25 HSBC Holdings and Standard Chartered, both headquartered in the United Kingdom, and Citibank, a U.S. bank, are considered 

the major international banks in China, having 

built a strong renminbi business.26 Netherlandsbased ING Bank also has a large presence, and 

Bank of America in June 2005 made the largest 

investment to date in a Chinese bank, purchasing 

9 percent of CCB for $3 billion dollars. 

Branches of Foreign Banks. Foreign banks in 

China currently operate under licenses that 

restrict them to specific clients and to certain 

geographical areas. They are permitted to provide 

financial services in nonlocal currencies to foreign firms in 18 cities, including Beijing. The 

CBRC reported that at the end of 2004, foreign 

banks had 18 percent market share of loans made 

in foreign currency. Additionally, by the end of 

2004, 105 foreign branches had received local 

currency (called renminbi or yuan) licenses, permitting them to collect deposits and make loans 

in renminbi in these same 18 cities. Of the 105 

foreign branches with renminbi licenses, 61 have 

been permitted to provide renminbi services to 

Chinese firms in addition to foreign firms.27 A 

major exclusion for these foreign branches is that 

they are not permitted to provide consumer services to Chinese individuals. 

In addition to client and geographical restrictions, 

the government has also used stringent licensing 

requirements to discourage the growth of foreign 

bank branches. Until recently, foreign banks 

were required to wait a year between branch 

openings in a city, and to maintain high minimum capital levels. In 2004, the government did 

away with the year’s wait and cut the minimum 

capital requirement for new branches. Foreign 

bankers claim that the lowered capital requirement still represents a barrier to entry in smaller 

cities. 

Foreign Joint Ventures. Despite the many problems of domestic banks, many foreign banks have 

also purchased minority positions in domestic 

banks to avoid existing client, geographic and 

branching restrictions and to obtain access to the 

domestic banks’ extensive branch systems. The 

government currently permits up to a total of 24.9 

percent foreign stake in any one domestic bank 

(19.9 percent by any one foreign entity). The 

government has also provided incentives to 

encourage foreign minority interest in Chinese 

banks. A significant incentive has been a lower 

tax for foreign businesses than for domestic businesses. 

In certain cases the government has also permitted significant concessions to foreign investors in 

Chinese banks. For example, Newbridge Capital, 

a U.S. private equity firm, recently bought 18 percent of Shenzhen Development Bank, a joint 

stock bank, and was permitted to appoint a 

majority of the board, ceding control of a Chinese 

bank to a foreign entity for the first time. And 

American Express was recently able to negotiate 

an agreement with Industrial & Commercial 

Bank of China under which the bank assumed all 

risk for the joint American Express card the two 

firms issued. 

One of the largest foreign investments in a Chinese bank is HSBC Holdings’ 19.9 percent share 

of Bank of Communications (BoCom), China’s 

fifth largest bank, which HSBC purchased for 

$1.75 billion. HSBC was able to negotiate government assistance and some protections. The 

government bailed out BoCom before the acquisition: BoCom’s current reported level of nonperforming loans is 3.4 percent. Its agreement also 

permitted HSBC to appoint two of the eight seats 

on BoCom’s board of directors, which is expected 

to assure some level of control.28 Additionally, 

PriceWaterhouseCooper is reorganizing BoCom’s 

risk management and accounting systems and 

Goldman Sachs is restructuring BoCom in preparation for its public listing. 

25 International Monetary Fund (2005).
 

26 Dolven et al. (2004). 


27 China Daily (2004).
 

28 Dolven et al. (2004).
 

FDIC BANKING REVIEW 7 2005, VOLUME 17, NO. 3 
 

 

China’s Opening to the World: What Does It Mean for U.S. Banks? 

A Look at Financial Opportunities 

The demand for financial services in China is 

huge and growing. Foreign bank interest in 

China speaks to the attractiveness of this market. 

A rising standard of living has sparked a growing 

demand by Chinese consumers for financial services, opening up opportunities for banks in wealth 

management, credit cards, mortgage loans, auto 

loans and other consumer loans. Economic 

growth has also produced a growing demand from 

private businesses for commercial and investment 

banking services. Emergent opportunities for foreign banks include providing loans to smaller 

businesses, deposit-taking, risk management services, debt and equity underwriting, mergers and 

acquisitions, brokerage, asset management, and 

disposal of bad loans. 

Opportunities: Retail Banking 

Some foreign banks view retail banking as a 

tremendous opportunity due to growing consumer 

demand and limited domestic competition. Chinese consumers are off-limits to foreign banks 

until December 2006, which has prompted some 

foreign banks to take minority positions in Chinese banks to prepare for this financial opening. 

Although personal financial services account for 

an insignificant percentage of the earnings for 

China’s banks—3 percent in 2003—this represents a huge increase over the past few years.29 

And, with a new middle class of approximately 

100 million consumers, the demand for credit 

cards, mortgage loans, and automobile loans is 

expected to increase further. McKinsey, a business consulting group, is projecting a compound 

annual growth rate for personal financial services 

in China of 31 percent through 2013.30 McKinsey considers two segments of the population 

attractive targets: the affluent, the top 2 percent 

of banking customers who currently account for 

over half of retail banking profits in China, and 

the “mass-affluent,” the 18 percent of Chinese 

bank customers who are responsible for most of 

the remaining profits.31 

Existing competition is weak. The personnel and 

technology of Chinese banks generally do not 

meet international standards and the local banks 

typically have not made customer service a priority.32 Additionally, recent forays into consumer 

lending by Chinese banks have been generally 

unsuccessful. A lack of experience in consumer 

lending, inadequate systems for sharing financial 

information, falsified financial documents and 

other fraud by borrowers, and difficulties in foreclosing and gaining title to collateral have produced a number of bad consumer loans. (This is 

covered in greater detail in a later section on 

risks.) 

As described, many large foreign banks, anxious 

to get a head start in consumer banking before 

the opening, have allied themselves with Chinese 

banks to offer wealth management; credit cards; 

and mortgage, auto, and other consumer loans. 

Many foreign banks have found city banks especially attractive investments. Restricted to operating in a single city, city banks often have close 

customer relationships. Additionally, there are 34 

cities in China with more than one million 

inhabitants, so city banks can provide substantial 

penetration. The CBRC has also said that it may 

eventually allow city banks to expand into other 

areas of China. 

Wealth Management. Chinese banks are permitted to sell mutual funds and to provide custody 

services to bank customers, but not to manage 

funds themselves. However, in February 2005 the 

CBRC initiated a pilot program under which 

banks would be permitted to launch funds on 

their own or with partners. Firewalls between a 

commercial bank’s banking operations and its 

fund management business are required.33 The 

central bank is expected to approve bank mutual 

funds at the end of September 2005. 

29 BNA’s Banking Report (2004) reports that consumer loans increased from
 

$17 billion in 1997 to $200 billion in 2004.
 

30 Von Emloh and Wang (2004). 


31 Ibid.
 

32 BNA’s Banking Report (2004). 

33 China View (2004). 

2005, VOLUME 17, NO. 3 8 FDIC BANKING REVIEW 
China’s Opening to the World: What Does It Mean for U.S. Banks? 

Fund sales have been a significant recent area of 

growth for some Chinese banks. In particular, 

CCB, the second largest bank in China, has been 

active in this area. CCB has 136 million active 

retail accounts and 14,500 branches across China. 

It reports that through March 2004 it sold 26 different mutual funds to investors with a sales volume of approximately $3.74 billion.34 As 

mentioned, Bank of America recently purchased 

9 percent of CCB to access its tremendous network and capabilities. 

ING Bank of the Netherlands and the International Finance Corp (World Bank) together own 

24.9 percent of the Bank of Beijing, the second 

largest of China’s city commercial banks, which 

has a large and growing consumer savings base. 

ING plans to offer wealth management services 

and insurance to these consumers through its 

venture partner. ING has stakes in five other 

Chinese banks and is engaged in joint ventures 

with Chinese firms in fund management and 

insurance as well.35 

Credit Cards. At the end of 2004, credit cards 

accounted for 3 percent of consumer purchases in 

China. American Express (AMEX) expects that 

penetration will eventually match Hong Kong’s 

20 percent rate.36 McKinsey believes foreign 

banks have a special advantage in credit cards 

because of a traditional Chinese unwillingness to 

lend without collateral and domestic banks’ lack 

of marketing and risk assessment skills. 

Foreign banks have begun to move into the credit 

card area through investments in domestic banks. 

For instance, Citibank purchased 5 percent of 

Shanghai Pudong Development Bank, the ninth 

largest commercial bank in China, with 270 

branches in major cities.37 The joint venture 

recently began to offer Chinese consumers international credit cards, denominated in renminbi 

within the country and in U.S. dollars outside of 

China. The card carries Citibank’s logo. HSBC 

has partnered with the Bank of Shanghai, of 

which it owns 8 percent, to offer credit cards. 

AMEX, with ICBC, recently launched the country’s first dual-currency American Express Card. 

Beginning in 2005, the government began to 

allow renminbi-currency credit cards to be used 

outside of China. They can be used in South 

Korea, Singapore, and Thailand; transactions 

related to gambling, interbank transactions, and 

capital-account items are prohibited. 

Mortgage Loans, Auto Loans, and Other Consumer Loans. Over five million new homes were 

built during the past five years in China.38 During the next decade economic growth is expected 

to provide home ownership opportunities for hundreds of millions of Chinese. KGI, a securities 

firm, reports that the number of mortgages grew 

at an annual compound rate of 115 percent 

between 1998 and 2004.39 As noted above, mortgages account for 90 percent of outstanding consumer loans of $242 billion. 

China is currently the world’s third-largest car 

market (after the United States and Japan), and 

some analysts expect it to overtake the United 

States (number one) by 2015. Demand for cars in 

China increased 56 percent in 2002 and 75 percent in 2003 before falling to a 15 percent growth 

rate in 2004, as the government tightened bank 

lending. Approximately 30 percent of autos were 

financed by loans in 2003; the figure dropped to 

10 percent in 2004 in response to the tightened 

lending. 

The demand for consumer goods of all types has 

increased dramatically in China, and not just in 

the large cities. More than half of the consumption of many consumer goods has occurred in the 

nation’s smaller cities and rural areas. HSBC has 

positioned itself to take advantage of this growing 

demand. Its investment in BoCom, described 

earlier, provides HSBC—through BoCom’s 2700 

branches—with access to 139 cities in China and 

massive consumer lending opportunities. 

34 Lafferty Limited (2005).
 

35 The Economist Intelligence Unit Ltd. (2005d).
 

36 Forbes.com (2004).
 

37 BBC News (2003).
 

38 Woetzel (2004).
 

39 The Economist (2005f), 73.
 

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China’s Opening to the World: What Does It Mean for U.S. Banks? 

Opportunities: Commercial and Investment 

Banking 

Foreign banks are currently providing commercial 

and investment banking services for foreign businesses operating in China, and have begun to 

provide limited financial services for Chinese 

businesses, as permitted. 

Foreign businesses in China include multinational 

businesses, such as Volkswagen, which produces 

cars for the domestic Chinese market, and other 

multinationals, such as Wal-Mart and General 

Electric, that are export-driven. Most foreign 

businesses operating in China are smaller, exportdriven, mostly Asian-owned businesses; these 

businesses represent higher-margin lending opportunities than the multinationals. Small and 

medium-sized Chinese businesses, starved for 

financing at a reasonable cost by the state-owned 

banks, also provide commercial and investment 

banking opportunities. 

Smaller private businesses present particularly 

attractive commercial and investment banking 

opportunities in China. These growing businesses 

provide opportunities in risk-based lending and 

corporate deposit-taking; equity and debt underwriting, trade financing, merger and acquisition 

assistance, brokerage services, and asset management. There are also opportunities for foreign 

banks in disposing of the huge amount of bad 

loans held by Chinese banks and asset management companies. 

Risk-based Loans and Deposit-taking. Private 

businesses in China account for approximately 60 

percent of China’s GDP and 70 percent of 

employment. As mentioned earlier, ignored by 

the state-owned banks, they are often forced to 

pay interest rates of as much as 8 to 20 percent or 

more for loans from gray-market lenders, if they 

are able to get them at all. This market continues 

to be underserved. McKinsey estimates that total 

bank revenues from loans to small and mediumsized businesses in China could exceed $25 billion 

by 2010; in 2002, they accounted for less than 

$10 billion.40 HSBC Holdings, in particular, has 

focused on lending to smaller companies in 

China.41 

McKinsey also sees corporate deposit taking as an 

attractive area of business for foreign banks. 

McKinsey estimates that deposits are likely to 

grow at approximately 18 percent annually 

through 2010, generating more than $20 billion 

to banks by 2010.42 

Risk Management Services. In March 2004, the 

government introduced rules permitting foreign 

banks to trade derivatives directly with Chinese 

businesses. The new legislation allows for assetrelated derivatives in credit, fixed income, foreign 

exchange, and hedging. ABN AMRO estimates 

revenue from interest rate derivatives at approximately $500 million a year and increasing, and 

plans to expand its derivatives business from foreign-currency hedging to interest rate swaps and 

to commodity and equity derivatives.43 By the 

end of 2004, ten banks had received licenses to 

trade derivatives. 

Debt and Equity Underwriting, Trade Financing, and Mergers and Acquisitions. A recent 

study by Mercer Oliver Wyman (a global financial services and risk management firm), in conjunction with Morgan Stanley and UBS AG, 

estimates that earnings from fees for investment 

banking services in non-Japanese Asia for 2004 

were approximately $5 billion, an increase of 30 

percent over 2003. Bloomberg News reports that 

the market for debt underwriting in non-Japanese 

Asia doubled in the past five years and that Citigroup was market leader in debt underwriting in 

2004 in this region.44 

With the government planning to launch IPOs of 

state-owned banks and other state-owned enterprises, equity underwriting is expected to grow 

substantially. Increasing numbers of private Chi40 Bowers et al. (2003). 11, 

41 Dolven et al. (2004). 

42 Bowers et al. (2003), 10, 

43 Baglole and Ng (2004). 

44 Bloomberg News (2004). 

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China’s Opening to the World: What Does It Mean for U.S. Banks? 

nese businesses are also expected to go public and 

to issue debt. McKinsey projects that revenues 

from underwriting equity and debt should grow at 

a compound annual rate of 13 percent to $2 billion by 2010, with half of this increase coming 

from medium and small businesses. Citigroup and 

Credit Suisse First Boston are active in underwriting IPOs. There are also opportunities in debt 

underwriting of private businesses: Morgan Stanley has been especially active in underwriting 

high-yield issues. 

Businesses also need trade financing. McKinsey 

projects that bank revenues from trade financing 

could reach $5 to $10 billion by 2010. HSBC 

Holdings, in particular, has built a very successful 

trade financing network for its small corporate 

clients.45 McKinsey also is projecting that merger 

and acquisition revenues will grow by 30 percent 

a year, reaching $400 million in fees by the end of 

the decade.46 

Brokerage and Asset Management. Opportunities in providing brokerage services are opening. 

Half of China’s 130 domestic brokerages are classified “at risk” and would find it difficult to provide significant competition to foreign brokers. 

However, China’s WTO commitments in regard 

to securities operations are less than its commercial banking commitments. Foreign firms will not 

be permitted to trade A-shares, which have 

accounted for the vast majority of Chinese securities firms’ revenues.47 Foreign investment banks 

are also limited to owning a 33 percent share of 

domestic securities firms, a limitation that is not 

slated to change under the WTO agreement.48 

However, in December 2004 the government 

approved a joint venture between Goldman Sachs 

and a local securities firm under which Goldman 

was granted effective control. The joint venture 

is permitted to trade shares on domestic markets. 

Asset management opportunities in China are 

discussed in the previous section on wealth management. As in brokerage, foreign ownership 

restrictions on asset management firms are to 

continue, with the maximum ownership by a foreign firm restricted to the 49 percent that was 

approved in December 2004. In April 2005, 

UBS purchased 49 percent of China Dragon Fund 

Management, a medium-sized Chinese mutual 

fund. 

Disposal of Bad Loans. China is the world’s second-largest bad-loan market (after Japan).49 S&P 

estimates that there are approximately $700 billion in bad loans in China; other analysts suggest 

a higher figure. As mentioned, the government 

has been pressuring the state-owned banks to dispose of bad loans in preparation for their IPOs, 

and it has created four asset management companies to dispose of the loans. Through the end of 

2004, the companies had sold only one-third of 

the $230 billion in bad loans acquired from the 

banks since 1999. 

Some foreign banks have shown interest in this 

area. Citigroup purchased over 16 percent of Silver Grant International, a real estate affiliate of 

China Cinda Asset Management, one of the four 

asset management companies. Credit Suisse First 

Boston has also been active in this market, 

recently purchasing a 2.4 billion yuan ($290 million) package of distressed loans from China Orient Asset Management Corporation, another of 

the four asset management companies. 

A Look at the Risks 

Although the exploding Chinese economy may 

be the envy of the world, there are potential economic, political and demographic problems. 

Major areas of concern are that the economy 

might be overheating, that countries on which 

China relies to buy its exports may become protectionist, that growing economic inequality 

could produce internal strife, and that the rapid 

aging of the population may create economic difficulties. 

45 Dolven et al. (2004).
 

46 Bowers et al. (2003).
 

47 Lardy (2002), 72.
 

48 McGregor and Guerrera (2004).
 

49 Pesek (2004).
 

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China’s Opening to the World: What Does It Mean for U.S. Banks? 

Other significant problems exist as well. The regulatory environment is uncertain, and a large 

unwieldy government bureaucracy continues to 

play a crucial role in many areas of business operation. Local party officials and local government 

officials are powerful and often corrupt and 

obstructionist. Within the banks themselves, corruption is widespread. The operations of Chinese 

businesses, including the banks, lack transparency. 

The legal system lacks impartiality, and it is generally accepted that judges continue to be influenced by party and government leaders and 

bribery. Bankruptcy laws are inadequate; enforcement of contracts and legal judgments is unreliable; there is an inadequate credit infrastructure 

and not enough trained personnel in law, 

accounting, and risk management; and the government’s commitment to an open economic system is not always apparent. 

The Economist Intelligence Unit awards China a 

rating of B for macroeconomic risk and B for 

financial risk. It rates China D for political stability risk, D for labor market risk, D for government effectiveness risk, and D for legal and 

regulatory risk.50 

Cause for Concern: An Overheating 

Economy? 

As described above, China’s growth since the 

early 1980s has been phenomenal. Much of this 

growth is investment-based: gross fixed investment constituted 45 percent of China’s GDP in 

2004. This high level of investment has resulted 

in overbuilding and excess capacity in some sectors. The government has responded by trying to 

stop this overbuilding so that business profitability remains strong and the banks are not engulfed 

with new nonperforming loans. Rising inflation 

is also a concern: if increasing investment-led 

demand for workers and materials results in inflation, it is feared that the value of savings will be 

eaten away, interest rates will increase, and the 

gains in the standard of living that many Chinese 

have attained in recent years will be pushed back. 

This could very well create political as well as 

economic reverberations. Another significant 

source of worry is China’s very low level of energy 

efficiency. According to the official Xinhua news 

agency, China consumes 4.3 times the amount of 

energy that the United States consumes in producing $10,000 in GDP.51 China is a net 

importer of energy, whose cost has risen significantly. This lack of energy efficiency has both 

inflationary and competitive implications.52 

To cool the economy, beginning in the spring of 

2004, the government put curbs on new lending 

and investment activity. Smaller banks were forbidden to undertake new lending, requirements 

for investments were tightened, and new price 

controls were instituted. Companies were 

required to use more of their own capital and less 

debt; and provincial governments were directed 

to carefully review all investments in steel, aluminum, cement, and real estate and—if inflation 

rose—to cap price increases in electricity and 

transportation. 

These cooling efforts apparently had some effect. 

Whereas the annualized increase in the investment in fixed assets in the first quarter of 2004 

had been more than 40 percent, the increase for 

the whole of 2004 was 25.8 percent (following a 

23.9 percent annual increase in 2003). But as 

mentioned, gross fixed investment still constituted 45 percent of GDP in 2004. 

Government efforts to slow bank lending were 

not completely successful either, as local officials 

proved adept at “sneaking” projects by the central 

government. Whereas credit growth declined to 

a 9.3 percent increase in 2004 compared with the 

previous year’s growth rate of 19.2 percent, the 

CBRC reported that Chinese banks made over 

$70 billion in unapproved loans in 2004, up 70 

percent over the amount of the previous year.53 

50 The Economist Intelligence Unit (2005c). 

51 The Economist Intelligence Unit (2005b). 

52 This inefficient use of energy also contributes to significant environmental 

pollution. 

53 Economist (2005a). 

2005, VOLUME 17, NO. 3 12 FDIC BANKING REVIEW 
China’s Opening to the World: What Does It Mean for U.S. Banks? 

The International Monetary Fund (IMF [2005]) 

cautions that to maintain control over its rapidly 

growing economy, China still needs to rein in its 

investment, raise interest rates, and loosen its currency. The IMF continues to be concerned about 

the quality of investment in China, and suggests 

that investment needs to be better targeted. Furthermore, although the IMF considers current 

inflation low given the extraordinary growth in 

the economy—inflation was 3.9 percent in 

2004—it sees some evidence of more widespread 

“cost-push” pressures, especially in wages and 

electricity. Other analysts are concerned by the 

booming real estate market in certain parts of the 

country. 

Cause for Concern: Protectionism? 

In 2003, China’s exports to the United States 

exceeded its imports by a ratio of 8 to 1. Its trade 

surplus with the United States that year was $124 

billion—the largest bilateral trade imbalance in 

history.54 The next year the trade surplus 

increased to $160 billion. However, China’s global trade surplus in 2004 was only $32 billion, for 

its high level of global imports—$561 billion in 

goods—largely offset its global exports of $593 

billion. Until the end of 2004, China’s textile 

exports were limited by an agreed upon cap with 

other nations. Following the expiration of the 

cap, China increased its textile exports dramatically—by 29 percent in the first quarter of 2005. 

China is now the world’s largest exporter of clothing, with 28 percent of world market share.55 

The magnitude of Chinese exports has caused 

consternation in the United States, the European 

Union, and other countries, and raises the specter 

of protectionism. As an export-dependent 

nation, China’s economy would be seriously 

derailed by U.S. or E.U. protectionism. 

China recently succumbed to pressure from the 

United States and other countries to raise the 

value of its currency. The yuan had been pegged 

at approximately 8.28 to the U.S. dollar for the 

past decade. The United States accused China of 

engaging in unfair trade by keeping its currency at 

an artificially low level against the dollar, making 

its exports less expensive. In July 2005, China 

changed the dollar peg to a peg against an 

unidentified basket of currencies, and at the same 

time allowed a 2.1 percent upward revaluation of 

its currency against the dollar. It also promised 

additional gradual movements over time. This 

revaluation is small and unlikely to have much 

effect on its exports or to satisfy its critics for 

long. The serious nonperforming-loan problem of 

Chinese banks, however, makes it extremely difficult for the government to respond to its foreign 

critics and to revalue its currency in a significant 

way. It is feared that a significant revaluation 

could result in increased bankruptcies and a deluge of new nonperforming loans, leading to serious economic turmoil and possibly a financial 

crisis. 

Cause for Concern: Growing Economic 

Inequality 

In China over 800 million people, or approximately 60 percent of the total population, continue to live in rural areas. The World Bank reports 

that although hundreds of millions of Chinese 

people have risen from absolute poverty over the 

past two decades and the illiteracy rate has 

decreased by more than half (from 37 percent in 

1978 to 17 percent in 1999), great poverty still 

exists in China, especially in rural areas. The 

bank reports that over 200 million mostly rural 

Chinese still live on less than $1.00 a day and 

lack access to clean water, arable land, and adequate education and health services.56 Credible 

unemployment estimates for those living in the 

countryside are hard to come by, but The Economist estimates that as many as 150 million rural 

Chinese are unemployed.57 

As mentioned, official 2004 Chinese statistics 

report that both urban and rural households experienced the highest growth rates in per capita disposable income since 1997. (The real growth rate 

54 Thompson (2004). 

55 Channelnewsasia.com (2005). 

56 World Bank (2003). 

57 The Economist (2004d). 

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China’s Opening to the World: What Does It Mean for U.S. Banks? 

for urban households was 7.7 per cent, and for 

rural households 6.8 percent.) However, this 

growth was from very different bases in the two 

cases. According to official statistics, for city 

dwellers in 2004 the average per capita disposable 

income was 9,422 yuan ($1,138 at the official 

2004 exchange rate), compared with 2,936 yuan 

($355)—less than one-third the income of urban 

households—for rural households.58 Also, much 

of the growth in income for rural areas in 2004 

was attributed to high grain production and high 

grain prices, both of which are unlikely to be sustainable, and to reductions in taxes and fees— 

reductions that have contributed to a further 

decline in the availability of decent education 

and health services for rural poor people.59 

In sum, there exists a real divide in China’s standard of living between those who live in cities 

and those who live in rural areas. This inequality 

produces political and economic friction. The 

government has been doing a number of things to 

help the rural poor: it is requiring more provinces 

to eliminate the farm tax, directing that 70 percent of additional provincial expenditures on 

health and education go to rural areas, and 

increasing farm subsidies and government investment in agriculture.60 Even so, economic 

inequality remains a growing problem. 

Cause for Concern: An Aging Population 

China’s population is probably aging faster than 

that of any country in history as a result of the 

nation’s one-child policy. Asian Demographics, a 

demographic research firm, describes China’s population trend as “a demographic earthquake.”61 It 

estimates that the growth of the under-40 age 

bracket may have already peaked in China, and is 

forecasting a decline of one-third—or 250 million 

people—in that bracket over the next 20 years. 

By 2024 three-quarters of Chinese households 

may be childless. 

This rapid aging carries with it not only all the 

problems that arise when there are fewer people 

to care for an aging population, but also the corresponding negative effect on domestic consumer 

demand. Based on this projected population 

decline, Asian Demographics forecasts annual 

increases in GDP in China of 4.8 percent over 

the next ten years and less than 4 percent thereafter, far below the 7-8 percent growth rate that 

many foreign investors are assuming—or the 7 

percent annual growth rate that the government 

feels necessary to solve its rural unemployment 

problem. According to the firm, most marketers 

are not factoring this lower growth into their 

long-term plans.62 

Bureaucratic Delay and Political 

Interference 

The Chinese government is more involved in 

business operations than most foreign banks are 

accustomed. And, the government bureaucracy 

in China remains unwieldy and opaque. Despite 

reforms enacted in response to foreign complaints 

about the bureaucratic process—reforms such as 

expedited licensing—long delays caused by 

bureaucratic overlap remain a problem. Lone 

Star Funds, a global investment firm, closed its 

Beijing office recently because of a lack of product (bad loans) due to the long delay in getting 

the necessary approvals from the overlapping 

government offices responsible for these transactions.63 Citigroup had to wait for almost a year 

for approval of its offer to buy 1.096 billion yuan 

in nonperforming loans—loans that the government was anxious to sell. However, in October 

2004 the government announced expedited sales 

of nonperforming loans—for foreign buyers only. 

Businesses contend not only with an overlapping 

national government bureaucracy, but also with 

local (at the village, town, city, county and 

provincial levels) government officials as well as 

local party officials. Local governments in China 

have exercised a great deal of power since the 

imperial days, and local government officials and 

58 National Bureau of Statistics of China (2005).
 

59 Economist Intelligence Unit (2005a).
 

60 Economic Intelligence Unit (2005a).
 

61 The Economist (2005b), 74.
 

62 Ibid.
 

63 Pesek (2004).
 

2005, VOLUME 17, NO. 3 14 FDIC BANKING REVIEW 
China’s Opening to the World: What Does It Mean for U.S. Banks? 

local party officials continue to have a great deal 

of influence on what happens in their villages, 

towns, cities, and provinces. Their commitment 

to a market economy is also sometimes questionable. (The commitment of the national government is discussed below.) 

Local political interference in banks has been 

especially widespread. Branch managers have historically had closer relationships with local government officials than with their bank superiors, 

and were rewarded more on the basis of loyalty to 

party and local officials than on the basis of market results.64 Until very recently, for all intents 

and purposes, bank branches were under the rule 

of local officials, who set bank salaries, guaranteed 

loans, and even were involved in decisions on 

where the children of bank employees went to 

school.65 Local officials guaranteed loans and 

recommended branch managers, and branches 

routinely disregarded risk and return to promote 

public purposes at the direction of party and local 

government officials. Political interference in 

lending decisions reportedly has lessened as the 

government has encouraged banks to adopt international banking practices, but it remains a force. 

Problems with Corporate Governance 

Corruption continues to be a problem in China, 

although there have been real improvements here 

as well. Transparency International, a global corruption-monitoring group, rated China 2.16 in 

1995 (a rating beneath 3.0 indicates rampant corruption). In 2005, the ranking improved to 3.4, 

placing China solidly in the middle in terms of 

corruption—71st out of 146 countries.66 Corruption has been especially a problem within the 

banks, and this must be an important consideration for a foreign bank deciding whether to compete in China through an equity position in a 

domestic bank and, if so, how to structure any 

such relationship. 

Corruption is considered to be especially prevalent in remote branches and rural institutions: 

private businesses have complained that in order 

to borrow from rural banks and credit cooperatives, they are typically forced to bribe lenders 

with kickbacks of 10 to 15 percent of the loan 

value.67 The rural credit cooperatives are reportedly riddled with fraud and controlled by local 

government officials. 

Corruption appears to be a problem not just in 

rural banks or remote branches but also in the big 

four banks. The central bank recently reported 

that 40,000 CCB employees and 18,000 Bank of 

China employees had been disciplined for misappropriating funds and making unauthorized 

loans.68 Additionally, the chairman of CCB was 

forced to resign in March 2005 for taking bribes. 

Significantly, CCB had been considered the 

cleanest of the big four banks. The CBRC also 

recently announced that it had charged dozens of 

government officials and bankers at ICBC with 

attempting to steal almost $1 billion from the 

bank. Earlier, the CBRC reported that the director of a branch of ICBC had disappeared with 

$120 million of the bank’s money. 

The Washington Post reports that there is also 

significant corruption and cronyism in the four 

asset management companies created by the government to dispose of the banks’ bad loans. The 

management companies are staffed with many of 

the same bankers who made the bad loans in the 

first place; and not surprisingly, the corruption 

and self-dealing have continued. The government audit office recently reported that it had 

uncovered 38 cases of embezzlement and fraud at 

the four companies, involving more than $800 

million.69 

These government disclosures of corruption can 

be viewed two ways, however. As mentioned earlier, the CBRC is making a strong effort to 

improve corporate governance at the banks, and 

many commentators see these public announcements of fraud as positive signs—as proof that 

64 The Economist (2004b).
 

65 The Wall Street Journal (2004). 


66 The Economist (2005c).
 

67 The Economist (2004a).
 

68 Although the big four banks employ a total of 1.4 million people, these
 

numbers are still very significant.
 

69 Washington Post (2005). 


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China’s Opening to the World: What Does It Mean for U.S. Banks? 

auditing and centralized management reforms are 

detecting fraud and that the government is serious about stopping it. 

The level of transparency in businesses, including 

Chinese banks, is also not good. Of particular 

concern, the accuracy of bank financial statements is questionable. Although HSBC has 

taken a minority position in many Chinese banks, 

its Asia chairman has cautioned that outside 

investors in Chinese banks need to be extremely 

careful, for they have found bank financial statements to be unreliable and the banks uncontrollable.70 Some of the problem may be that the 

banks themselves do not keep track of operating 

data. McKinsey reports that one state-owned 

bank had to spend a month reviewing records and 

interviewing personnel to arrive at an estimate of 

its losses and recoveries from defaulted loans.71 

International accounting standards are only used 

on the small number of publicly listed businesses. 

Poor Systems for Ensuring the 

Return of Capital 

China has poor systems72 to ensure the safe return 

of capital. Its current laws and foreclosure procedures are ineffective, and creditors have few 

rights. The judicial system is considered biased 

and corrupted by local officials and bribery. 

Enforcement of contracts and of legal judgments 

is problematic. The credit infrastructure is inadequate, and there are shortages of trained personnel in crucial management areas. The 

commitment of the government to a market 

economy is not always clear. 

Inadequacy of Bankruptcy Laws. China lacks 

effective bankruptcy laws and foreclosure procedures. The bankruptcy law enacted in 1986 has 

been described as incomplete, inconsistent, and 

opaque.73 It required criminal fraud investigations in the case of bankrupt companies, and liquidation was the only way to resolve bankruptcy. 

The law gave creditors few rights and was ineffective in enforcing contractual obligations. With 

the government acting as shareholder, arbiter, and 

creditor, there was also an inherent conflict of 

interest.74 The government was responsible for 

approving bankruptcy petitions and appointing 

liquidators (often local government officials). 

A new bankruptcy law has been pending for a 

decade and is expected to be enacted sometime in 

2005. The current version of the proposed law 

has many of the elements of U.S. law and is 

expected to conform to WTO requirements. It 

would apply uniformly to both state-owned and 

private enterprises, with some exceptions. A 

court rather than the government would rule on 

bankruptcy petitions. Liquidation of the assets of 

the bankrupt entity would be the responsibility of 

an administrator selected by the court rather than 

by the government, and the administrator would 

be supervised by a committee of creditors who 

would have the right to approach the court to 

replace the administrator. The current version of 

the proposed law also recognizes that businesses 

may fail for a variety of reasons other than criminal mismanagement, and it is similar to Chapter 

11 proceedings in U.S. law in that it would allow 

for corporate reorganization under a bankruptcy 

court’s advisement, with the approval of major 

creditors. Security interests would be honored 

(that is, collateral would be sold to satisfy the 

debt).75 The draft law provides an exemption 

period for some state-owned enterprises. 

Failure to Enforce Contracts. China has severe 

problems with the enforcement of contracts and 

legal judgments. The China Law and Governance 

Review (2004) finds that China’s courts lack the 

“authority and stature” to enforce their decisions, 

especially when other branches of the government, or government officials, are parties to the 

case. The Review estimates that approximately 30 

to 60 percent of legal judgments in China are 

enforced. Because local protectionism is an 

important factor in the enforcement of judg70 The Economist (2005d).
 

71 Desvaux et al. (2004).
 

72 The term “systems” is used in a broad sense to include all the mechanisms
 

necessary for the smooth functioning of a capitalistic system, i.e, laws, procedures, infrastructure, and personnel. 


73 Fisher (2005).
 

74 Bayron (2005).
 

75 Fisher (2005).
 

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China’s Opening to the World: What Does It Mean for U.S. Banks? 

ments, this number can drop to 10 percent in 

areas outside the geographical jurisdiction of the 

court. The enforcement of legal judgments of all 

kinds is problematic—whether the issue is compensation for damages, repayment of debt, or 

enforcement of property rights. Enforcement of a 

judgment is often a “contest of influence or 

power.”76 

Commercial and economic judgments are especially difficult to enforce. The China Law and 

Governance Review reports that during the first 

half of 2003, there were twice as many unexecuted civil and economic judgments in Beijing as 

executed judgments. Most of these unexecuted 

judgments were for either bank loan defaults or 

real estate judgments. A third major category of 

unexecuted judgments was wages: as of 2003, 

migrant workers in China were owed approximately $12.5 billion in unpaid wages. 

Inadequacy of a Credit Infrastructure and 

Trained Personnel. An additional systemic problem is the inadequacy of the credit infrastructure 

and a lack of crucial personnel. As mentioned 

above, Chinese statistics, including trade statistics, are not considered trustworthy. China also 

does not have a highly functioning credit culture 

or highly functioning credit systems. Only the 

relatively few public businesses use international 

accounting standards. Systems for uncovering 

and discouraging fraud are inadequate: external 

auditing, and internal control systems are undeveloped, and business transparency is not typical. 

Personal income statements are easily misrepresented, credit-rating services are immature, banks 

do not have easy access to other banks’ data to 

check on unreported debt or default histories, and 

the foreclosure process, as described earlier, is in 

flux.77 Few channels for risk shifting exist 

because the government has not permitted the 

securitization of loans.78 The markets are illiquid 

and lack good risk-hedging instruments. Consequently, as mentioned earlier, Chinese banks have 

begun to experience serious problems with many 

of the consumer loans they have made, especially 

auto loans, in a large part due to the inability of 

the banks to substantiate consumer information 

and to repossess property. 

Regarding personnel, despite the abundance of 

unskilled labor in many parts of China, unskilled 

labor is in short supply in the south of the country, and skilled labor is even harder to find. In 

addition, insufficient local personnel are available 

for top and middle level management. The Economist believes that although for most firms production in China remains cost-effective, a 

growing shortage of executives requires that substantial time be directed away from sales to 

human resources, with the result that growth may 

be slowed. Businesses in China complain about 

not being able to find personnel with “creativity 

. . . an aptitude for risk-taking and . . . an ability 

to manage in everything from human resources 

and accounting to sales, distribution, branding 

and project-management.”79 

Uncertainty about the Government’s Commitment to Open Competition. It is not always 

clear how committed the government (even the 

national government) is to free competition. The 

Chinese media recently reported a statement by 

the Vice-Chairman of the CBRC—subsequently 

disavowed—that after 2006 China might continue to limit the expansion of foreign banks to protect local banks from excessive competition. He 

stated that the government might restrict foreign 

banks to the poorer western areas of China and 

that foreigners might be forbidden to invest in 

more than two local banks. The Vice-Chairman 

defended his position by emphasizing that foreign 

banks held only 3 percent of the assets of the 

banking system but had a 12 percent share of the 

market in Shanghai, the business capital of 

China.80 As noted, this statement was later disavowed. 

76 China Law and Governance Review (2004). 


77 The Economist (2004c).
 

78 The Economist (2005f). 


79 The Economist (2005e), 60.
 

80 Financial Times (2005).
 

FDIC BANKING REVIEW 17 2005, VOLUME 17, NO. 3 
China’s Opening to the World: What Does It Mean for U.S. Banks? 

Concluding Remarks 

China presents great opportunities as well as great 

risks—a combination that each foreign bank must 

weigh for itself. The opportunities include a 

booming market of 1.3 billion people, many of 

whom are rising to middle-class status; stagnant 

competition from the local capital markets and 

banks; and emergent opportunities for banks in 

retail, commercial, and investment banking. 

The risks are also substantial. There are risks of 

an overheating economy, of rising protectionism 

in those countries which buy China’s products, of 

growing economic inequality in a non-democratic 

society, and problems associated with a rapidly 

aging population. Additionally, there is a slow 

moving bureaucracy; government interference in 

business operations at both the national and the 

local level; and poor corporate governance, 

including corruption and lack of transparency. 

The legal system in China, in its current form, 

cannot be relied on to protect creditor rights. 

Moreover, the degree of government commitment 

to an open market is not always clear. 

There have been improvements, however, and 

when (if) the new bankruptcy law is enacted, 

banks will have more protection. The Chinese 

banks in particular, with their massive portfolios 

of bad loans, should benefit and become both 

more competitive and more attractive as investments. The business of buying and selling nonperforming loans should also benefit. However, 

enactment of the bankruptcy law alone will not 

solve the bad loan problem. The law will have to 

be enforced, and enforcement requires unbiased 

courts, a government willing to remain neutral, 

harmonization of this law with other laws, and a 

cadre of legal and business professionals. 

Each foreign bank must decide for itself whether 

the opportunities of doing business in China outweigh the risks. Banks that have decided to enter 

this market must also decide whether to enter 

independently or as a partner with a Chinese 

bank. Because of a history of government-directed lending, political interference, corruption, and 

lack of modern management skills and systems, 

many Chinese banks are badly functioning institutions that are kept alive by government assistance. 

The lack of transparency of Chinese banks also 

makes them uncertain investments. Skepticism 

about the health of bank portfolios is widespread, 

even after massive bailouts. Nicholas Lardy, a 

renowned China expert at the Institute for International Economics, doubts the value of recent 

bank bailouts, suspecting that these massive infusions of government capital are too little and too 

soon—a waste of money until basic market 

reforms are made within the banks. His estimate 

of the amount of money needed to bail out the 

entire banking system is approximately 30 percent 

of China’s GDP over the next several years.81 

Potential investors in China must recognize the 

corporate governance problems, including corruption and the lack of transparency in Chinese businesses, including the banks, and must negotiate 

significant protections. They need to be very 

careful in their investments and seek out relationships that either provide them with substantial 

control or otherwise limit their risk. As we have 

seen, the Chinese government and Chinese businesses have shown themselves willing to craft special arrangements that provide some protection 

for foreign investors. However, competitive 

forces can obviate even standard protections. For 

example, in the area of debt underwriting, local 

Chinese firms have resisted strict covenants typical of junk bond issues, and with the strong 

demand for Chinese debt, there is concern that a 

race to the bottom could begin with underwriters 

agreeing to do away with standard investor protections.82 Such actions would be dangerous 

given the conditions described in this article. 

81 The Economist (2004b). 

82 Leahy (2005). 

2005, VOLUME 17, NO. 3 18 FDIC BANKING REVIEW 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

China’s Opening to the World: What Does It Mean for U.S. Banks? 

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FDIC BANKING REVIEW 19 2005, VOLUME 17, NO. 3 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

China’s Opening to the World: What Does It Mean for U.S. Banks? 

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———. 2004b. Non-Performing. March 20.
 

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———. 2004d. China’s Growing Pains. August 21, 11-12.
 

———. 2005a. No Sign of a Landing. January 29.
 

———. 2005b. China’s Golden Oldies; Business in China. February 26. 


______. 2005c. Survey: The Insidious Charms of Foreign Investment. March 5.
 

———. 2005d. China Corruption Bank—A Bank Scandal in China. March 29.
 

———. 2005e. China’s People Problem: Human Resources. April 16.
 

———. 2005f. Consumer Lending in China: Safe as Houses? April 23.
 

———. 2005g. Mainland China’s Stockmarkets: Hangover Cure. May 7.
 

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2005, VOLUME 17, NO. 3 20 FDIC BANKING REVIEW 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

China’s Opening to the World: What Does It Mean for U.S. Banks? 

National Bureau of Statistics of China. 2005. Stable and Rapid Development of the 

National Economy in 2004. 

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Challenges. July. 

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FDIC BANKING REVIEW 21 2005, VOLUME 17, NO. 3 

Overview of Recent Developments 

in the Credit Card Industry 

by Douglas Akers, Jay Golter, Brian Lamm, and Martha Solt* 

Since the 1980s, Visa U.S.A. (Visa) and MasterCard International (MasterCard), the bank-controlled credit card associations that together 

account for approximately 70 percent of today’s 

credit card market, have been able to control the 

use of and access to their networks to the advantage of their bank members. Recently, however, 

the credit card industry has been changing:1 some 

merchants are now large enough to exert their own 

leverage, legal defeats have impeded the ability of 

credit card associations to control the market, and 

some participants have developed new arrangements and alliances that may be a prelude to further changes in the industry. This article surveys 

recent developments in an industry that is facing 

new competitive dynamics. 

The article begins by describing the formation of 

the payment card industry and then its structure. 

The article continues by explaining the functioning of credit card networks: the various kinds of 

network models, and the significance of interchange fees in the most complex model. Next discussed are recent industry-altering litigation 

involving Visa and MasterCard, and significant 

aftereffects of the litigation. The article concludes 

by noting the main challenges facing the industry 

today. 

The Formation of the Credit Card Industry 

Although merchant credit may be as old as civilization, the present-day credit card industry in the 

United States originated in the nineteenth century. In the early 1800s, merchants and financial 

intermediaries provided credit for agricultural and 

durable goods, and by the early 1900s, major U.S. 

hotels and department stores issued paper identification cards to their most valued customers. When 

a customer presented such a card to a clerk at the 

issuing establishment, the customer’s creditworthiness and status were instantly established. The 

cards enabled merchants to cement the loyalty of 

their top customers, and the cardholders benefited 

by being able to obtain goods and services using 

preestablished lines of credit. Generally these cards 

were useful only at one location or within a limited geographic area—an area where local merchants accepted competitors’ cards as proof of a 

customer’s creditworthiness. 

* All the authors are in the Division of Insurance and Research at the Federal 

Deposit Insurance Corporation. Douglas Akers is a research assistant, Jay 

Golter a financial analyst, Brian Lamm a senior financial analyst, and Martha 

Solt a senior economist. 

1 The term “credit card industry” as used in this article refers to the four 

major payment card networks: Visa, MasterCard, American Express, and 

Discover. In addition, Diners Club is a very small participant. 

FDIC BANKING REVIEW 23 2005, VOLUME 17, NO. 3 
 

 

 

Overview of Recent Developments in The Credit Card Industry 

In 1949, Diners Club established the first generalpurpose charge card,2 enabling its cardholders to 

purchase goods and services from many different 

merchants in what soon became a nationwide network. The Diners Club card was meant for highend customers and was designed to be used for 

entertainment and travel expenses. Diners Club 

charged merchants who accepted the card 7 percent of each transaction. Merchants found that 

accepting Diners Club cards brought more customers who spent more freely. The Diners Club 

program proved successful, and in the following 

decade it spawned many imitators. 

In the late 1950s, Bank of America, located on the 

West Coast, began the first general purpose credit 

card (as opposed to charge card) program. At that 

time, banking laws placed severe geographic 

restrictions on individual banks. Virtually no banks 

were able to operate across state lines, and additional restrictions existed within many states. Yet 

for a credit card program to be able to compete 

with Diners Club, a national presence would be 

important. To increase the number of consumers 

carrying the card and to reach retailers outside of 

Bank of America’s area of operation, therefore, 

other banks were given the opportunity to license 

Bank of America’s credit card. At first Bank of 

America operated this network internally. As the 

network grew, the complexity of interchange—the 

movement of paper sales slips and settlement payments between member banks—became hard to 

manage. Furthermore, the more active bank 

licensees wanted more control over the network’s 

policy making and operational implementation. To 

accommodate these needs, Bank of America spun 

off its credit card operations into a separate entity 

that evolved into the Visa network of today. 

In 1966, in the wake of Bank of America’s success, 

a competing network of banks issuing a rival card 

was established. This effort evolved over time into 

what is now the MasterCard network. In addition, 

firms that were not constrained by interstate banking restrictions formed card networks on the single-issuer model (the model established by Diners 

Club, in which many merchants accept payments 

on a card with a single issuer; see the discussion of 

figure 2). For instance, the American Express 

Company (American Express) introduced its 

charge card system in 1958, and Sears, Roebuck 

and Co. (Sears) established the Discover Card 

credit card in 1986.3 

Among the challenges each of these networks 

faced was bringing together large numbers of cardholders with large numbers of merchants who 

accepted the cards as payment. Achieving a sufficiently large network was hard, partly because merchants, especially larger retailers, were reluctant to 

honor credit cards that would compete with their 

own store-branded credit cards. Some smaller merchants, however, viewed general-purpose credit 

cards as a way they could compete with larger merchants for customers.4 Merchants of all sizes were 

averse to having fees imposed on them by the 

credit card network. 

Currently the U.S. credit card industry is a mature 

market. Today credit cards are widely held by consumers: in 2001 an estimated 76 percent of families 

had some type of credit card.5 Recent estimates 

suggest that among all households with incomes 

over $30,000, 92 percent hold at least one card,6 

and the average for all households is 6.3 credit 

cards.7 Credit cards are also widely accepted by 

merchants, and with the recent addition of fastfood and convenience stores to the credit card networks, credit card payments are now processed at 

nearly all retail establishments. 

2 The holder of a charge card, unlike the holder of a credit card, must pay
 

the monthly statement balance in full.
 

3Whereas American Express processes all of its credit- and charge-card
 

activity through the American Express Bank, a wholly owned subsidiary it has
 

held for nearly 100 years, Discover processes all of its card-related
 

transactions through Greenwood Trust, a wholly owned subsidiary of
 

Discover’s parent company, Morgan Stanley Dean Witter & Co. (In order to
 

process the Discover Card transactions, Sears, Roebuck and Co. purchased
 

Greenwood Trust through its Allstate Enterprises subsidiary in 1985 and
 

converted it to a nonbank bank. Morgan Stanley purchased the bank, along
 

with Dean Witter and Discover, in 1997.)
 

4 For more information on the history of credit cards, see Evans and
 

Schmalensee (2005) and Mandell (1990).
 

5 Aizcorbe, Kennickell, and Moore (2003). This is the most recent data on
 

this topic from the Federal Reserve Board.
 

6 Gould (2004).
 

7 Day and Mayer (2005). 

2005, VOLUME 17, NO. 3 24 FDIC BANKING REVIEW 
 

Overview of Recent Developments in the Credit Card Industry 

The Structure of the Credit Card Industry 

As noted above, the general-purpose card market 

is dominated by Visa and MasterCard, two bankcontrolled card associations. Table 1 shows the 

U.S. market share of the top four card networks, 

with Visa and MasterCard together holding about 

70 percent of the market share. 

Table 1 

sidiary MBNA America Bank, NA (MBNA), a 

monoline credit card bank,12 and Washington 

Mutual, Inc. (Washington Mutual) is acquiring 

Providian Financial Corporation, including its Providian National Bank (Providian), another monoline credit card bank. The implications of these 

transactions are addressed below. 

Table 2 

Total U.S. Transaction Volume 

Fiscal Year Ending September 30, 2004 

Purchases and 

Cash Advances Market Share 

Card Network ($ billions) (percentage) 

Visa $526.87 39.8 

MasterCard 399.90 30.2 

American Express 304.80 23.0 

Discover Card 93.67 7.0 

Total $1,325.24 100.0 

Source: The Nilson Report, Issues 825 and 826, HSN Consultants 

The four major card networks have a variety of 

corporate structures. Visa is a nonstock for-profit 

membership corporation that as of 2004 was 

owned by approximately 14,000 financial-institution members from around the world.8 Until 2003 

MasterCard was a nonstock not-for-profit membership association, but then it converted to a privateshare corporation known as MasterCard Inc., with 

the association’s principal members becoming its 

shareholders. MasterCard has more than 23,000 

members (including the members of MasterCard’s 

debit network).9 The Board of Directors of Visa is 

elected by the member banks with voting rights 

based primarily on transaction volume.10 Control 

of the Visa and MasterCard card associations is 

roughly proportional to the transaction volume of 

member issuing banks. American Express is an 

independent financial services corporation, and 

Discover Financial Services (Discover) is now a 

subsidiary of investment bank Morgan Stanley 

Dean Witter & Co. (Morgan Stanley).11 

The issuance of credit cards is concentrated among 

five banks (table 2). Further concentration will 

result from two acquisitions announced in June 

2005: Bank of America is acquiring the holding 

company MBNA Corporation, including its subTop Bank Credit Card Issuers 

2004 

Outstandings 

Rank Bank Name ($ millions) 

Number of 

Active Accounts 

(in thousands) 

1 JP Morgan Chase $134,700 

2 Citigroup 115,950 

3 MBNA America 82,118 

4 Bank of America 61,093 

5 Capital One 53,024 

6 HSBC Bank 19,670 

7 Providian 18,536 

8 Wells Fargo 13,455 

9 U.S. Bancorp 10,578 

10 USAA Federal Savings 7,104 

Total $516,228 

42,966 

47,880 

21,199 

18,773 

24,429 

13,870 

8,726 

2,789 

4,056 

1,956 

186,644 

Source: American Banker 

In the industry today, debit cards are a fast-growing 

product line. Debit transactions reached a record 

$15.6 billion in 2003 (see table 3). Debit cards are 

essentially ATM cards that can be used on Visa, 

MasterCard, or other networks as well as at ATM 

machines. The amount of a payment made using a 

debit card is immediately withdrawn from the 

cardholder’s checking account, with the result 

that, for the card issuer, both the opportunity to 

earn interest on revolving balances and any inherent credit risk are eliminated. 

The ability to use the Visa and MasterCard networks to post debit transactions was developed in 

the 1970s, but not until the 1990s was there a sig8 Visa U.S.A. Inc. (2005).
 

9 MasterCard International (2005).
 

10 Evans and Schmalensee (2005).
 

11 See Note 3. Whether Discover will remain a subsidiary of Morgan Stanley
 

is uncertain as of this writing and is discussed more fully below.
 

12 A monoline bank engages primarily in only one line of business. 


FDIC BANKING REVIEW 25 2005, VOLUME 17, NO. 3 
Overview of Recent Developments in The Credit Card Industry ecent Developments in The Credit Card Industry 

Table 3 

Annual Number of Noncash Payments 

2000 and 2003 

Compound 

2000 2003 Annual 

Estimate Estimate Growth Rate 

($ billions) ($ billions) (percent) 

Check $41.9 $36.7 4.3 

Credit Card 15.6 19.0 6.7 

ACH 6.2 9.1 13.4 

Offline Debit 5.3 10.3 24.9 

Online Debit 3.0 5.3 21.0 

Electronic Benefits Transfer 0.5 0.8 15.4 

Total Noncash Payments $72.5 $81.2 3.8 

Source: Federal Reserve System 

nificant volume of transactions in these systems. If 

a merchant has a personal identification number 

(PIN) entry keypad at its sales location, the transaction is routed much the way an ATM transaction is. In the absence of a keypad, the merchant 

can have the customer sign a transaction authorization. These transactions then travel through the 

payment systems much as a credit card transaction 

does (except that the cardholder’s bank will be 

informed of the transaction immediately and will 

be able to hold the customer’s funds until settlement is completed). The differing fees charged to 

merchants for transacting PIN debits and signature 

debits became the basis for an important lawsuit 

that is described more fully below. 

Control of debit card transaction processing is 

mostly in the hands of banks. In Germany, however, half of all debit transactions are processed via a 

merchant-controlled debit card system by piggybacking on the low-cost Automated Clearinghouse 

network, and the system has no interchange fees. 

In the United States, Debitman Card Inc. has 

been working on such an effort for PIN-based debit 

transactions.13 

The Functioning of Credit Card Networks: 

Models and Interchange Fees 

The most complex form of credit card network is 

the one with the greatest number of participants: 

the multi-issuer card model. The cards in a multiissuer network represent a complex form of twosided markets whereby merchants are more willing 

to accept cards that have many cardholders, and 

cardholders want cards that are accepted at many 

establishments. The payment network benefits the 

merchant and the buyer jointly and entails joint 

costs, and it must price its service so that it gets— 

and keeps—the two sides participating in the network.14 It does this largely by setting interchange 

fees at levels that will maintain balance in the 

incentive structures of issuing banks (banks that 

issue credit cards) and acquiring banks (banks that 

service merchants and process their credit card 

transactions).15 Interchange fees are collected by 

issuing banks when they send payments for purchases to acquiring banks. 

Network Models 

Figures 1 through 3 illustrate the increasing complexity of a credit card network as more parties 

participate. Figure 1 illustrates the simplest bilateral model, where information and funds flow 

between a merchant and a cardholding customer 

when the merchant extends credit. On a monthly 

basis, the merchant will present a bill to the cardholder listing all transactions for the month. The 

cardholder then remits payment. 

Figure 2 illustrates the single-issuer model, which 

has a more complex closed-loop card-association 

system in which many merchants accept payments 

on a card with a single issuer. In this system, the 

merchant sends information about each purchase, 

including the customer account number, the transaction amount, and verification to the card issuer. 

With modern telecommunications and data processing technology, these steps are usually completed at the point of sale. The card issuer pays the 

merchant and sends a monthly statement to the 

cardholder listing all transactions which occurred 

during the statement period. The customer then 

pays the balance due, in whole or in part, based on 

the credit terms that were extended to the card13 FinanceTech (2004). 

14 Evans (2002). 

15 Schmalensee (2001). 

2005, VOLUME 17, NO. 3 26 FDIC BANKING REVIEW 
Overview of Recent Developments in the Credit Card Industry 

Figure 1 

Bilateral Model 

$ 

Monthly Statement 

Source: Federal Deposit Insurance Corporation. 

Cardholder Merchant 

holder by the issuer. This description applies to 

the original Diners Club model and, until very 

recently, to the Discover Card and American 

Express models (which have now converted to the 

multiple-card-issuer model, see figure 3). 

Finally, figure 3 provides a basic illustration of the 

most complex model, the model with one card 

association, many cardholders, many merchants, 

and multiple banks. In this model, the card association (or network) plays an important role by 

imposing rules for issuing cards, clearing and settling transactions, advertising and promoting the 

brand, authorizing transactions, assessing fees, and 

allocating revenues among transaction participants. Further, each participant in the credit card 

transaction has an incentive for participating in 

the network.16 Figure 3 shows the typical flow of 

information and funds for a sample $100 credit 

card purchase. The process begins when the cardholder presents the credit card to the merchant to 

purchase a good or service. The merchant transmits to the acquiring bank the cardholder’s 

account number and the amount of the transaction. The acquiring bank forwards this information to the card association network requesting 

authorization for the transaction. The card association forwards the authorization request to the 

issuing bank. The issuing bank responds with its 

authorization or denial through the network to the 

acquiring bank and then to the merchant. If 

approved, the issuing bank also sends to the 

acquiring bank, via the network, the transaction 

amount less an interchange fee.17 The interchange fee is established by the card association. 

The example illustrated in figure 3 shows $98.00 

($100.00 purchase price minus 200 basis point 

interchange fee) flowing from the issuing bank, 

though the network, to the acquiring bank. The 

acquiring bank, after subtracting its own service 

Figure 2 

Figure 3 

Single-Issuer Model 

$ and
 

$
 transaction 

authorization 

Note: Although Discover and Amercian Express were originally set up with a 

single-issuer model, both have recently switched to a multiple card issuer 

model (see Figure 3). 

Source: Federal Deposit Insurance Corporation. 

Cardholder Merchant Account information 

Monthly 

statement 

Transaction 

information 

Closed-Loop Card Association 

(e.g. Diner's Club, Discover, and American Express) 

Multiple Card Issuer Model 

Example of Flow of Payments in $100 Credit Card Purchase 

Authorization
 

response. If
 Authorization 

approved, response. If 

issuing bank approved, card Authorization Authorization association 

$98 to card 

later sends request request sends $98 to 

association merchant's 

($100 minus 200 bank. 

basis point fee). 

Cardholder Merchant 

Card Association (e.g. Visa/MasterCard) 

Card Association receives a transaction fee of about $0.05 per transaction. 

Source: Federal Deposit Insurance Corporation. 

Issuing 

Bank 

Acquiring 

Bank 

Monthly Transaction $100 statement information 

Account information 

Merchant 

receives $97.50 

($98 payment 

minus 50 basis 

point acquiring 

bank fee). 

fee, passes the payment on to the merchant.18 In 

figure 3, the merchant receives $97.50 ($98.00 

16 See also figure 4.
 

17 Funds flow between the card association and participating banks, not on a
 

transaction-by-transaction basis but on a batch basis, several times per day,
 

with the card association effecting settlement among the participating banks
 

by determining each of their net positions in order to balance the system.
 

18 The Acquiring Bank sets its own fee which is deducted from the merchant
 

payment. That fee must be high enough to cover the cost of the interchange
 

fee and the Acquiring Bank’s own expenses for the transaction. Interchange
 

fees amount to a large portion of the fees charged to merchants by Acquiring
 

Banks, and changes in interchange fees in the past have led to roughly equal
 

changes in fees charged to merchants. See Schmalensee (2001). 


FDIC BANKING REVIEW 27 2005, VOLUME 17, NO. 3 
Overview of Recent Developments in The Credit Card Industry 

minus a 50 basis point fee).19 

Acquiring banks can outsource these functions. 

One such company that provides outsourcing services is First Data Corporation which handles over 

50 percent of all MasterCard and Visa transactions 

processed at the point of sale.20 The profit margins 

for servicing merchant processing of credit card 

payments are thin,21 and the competition is based 

on discount fees, support services, and the handling of chargebacks (which are the reversals of 

charges). The issuing bank bills the cardholder for 

the full amount of the purchase and receives payment from the cardholder. The card association 

receives a small fee, usually around $0.05, for each 

transaction. 

Figure 4 lists the costs and benefits to each type of 

participant in the credit card industry. In order to 

benefit from economies of scale, the card associations must construct rules that balance each party’s 

needs so that large numbers of participants of each 

type choose to join (and stay in) the network. 

Over time, the dynamics among the various parties 

may change, with the result that network policies 

may need to be reassessed. 

Interchange Fees 

Interchange fees are set by the card associations 

and in 2004 were a source of some $25 billion in 

revenue to card issuers.22 At the same time, interchange fees are a source of irritation to merchants 

and can be among the largest and largest-growing 

costs of doing business for many retailers.23 A standard interchange fee is around 200 basis points, 

plus $0.10 per transaction, but many transactions 

have lower fees and some have higher fees. Large 

merchants can negotiate directly with the card 

association for very low interchange fees, but these 

fees are not publicly circulated. 

The pricing structure of interchange fees is complex. The specific interchange fee depends on the 

card association, the type and size of merchant, the 

type of card, and the type of transaction. Merchants that sell low-margin items—for example, 

convenience stores, supermarkets, and warehouse 

clubs—have lower rates. Hotels and car rental 

establishments have higher rates. Newer premium 

credit cards that offer more rewards have high 

rates. Credit card transactions have higher rates 

than signature debit card transactions, whose rates 

are higher than PIN debit card transactions. Sales 

transacted over the telephone or Internet have 

higher interchange rates, ostensibly to compensate 

for the greater risk of fraud associated with transactions that are not conducted in person. 

There is considerable friction among network participants over the issue of interchange fees, and 

card associations are being challenged on the 

structure and application of those fees. Merchants 

increasingly view interchange fees as an unnecessary and growing cost over which they have no 

control. Furthermore, banks are now issuing credit 

cards with even higher interchange fees. Merchants are unable to refuse transactions made with 

these cards. Therefore, merchants perceive issuing 

banks as earning revenue at their expense, with no 

added value to merchants. Merchants pass on the 

costs of interchange fees to their customers, who 

are largely unaware of this cost. 

Among other factors, the interchange fee structure 

that favors large merchants over smaller ones is 

inspiring merchants to challenge the interchange 

system more actively. Early in 2005, merchants 

formed a trade association for the purpose of 

changing interchange fees.24 In addition, Visa and 

MasterCard will be defending the interchange 

arrangement anew from litigation filed in June 

2005 by a group of smaller merchants.25 

Despite merchant discontent, card issuers have 

incentives to maintain or increase interchange 

fees. Issuers are marketing credit cards with reward 

or loyalty programs that encourage greater card use 

and reinforce customer loyalty to the brand. An 

estimated 12 to 24 percent of cards held by con19 Chakravorti (2003) presents a fuller description of the participants in the 

credit card industry and of the costs and benefits to each.
 

20 Kissane and Duca (2005).
 

21 Wong (2004a).
 

22 Aite Group (2005).
 

23 Wilke and Sidel (2005).
 

24 Digital Transactions (2005) and American Banker Online (2005).
 

25 Kuykendall and Lindemayer (2005).
 

2005, VOLUME 17, NO. 3 28 FDIC BANKING REVIEW 
 

Overview of Recent Developments in the Credit Card Industry 

Figure 4 sumers have rewards associated with 

Benefits and Costs for Participants in the 

Credit Card Industry 

Type of 

Participant Function Benefits Costs 

Cardholder � Purchases � Convenience of � Interest rates 

goods and making and fees 

services purchases � Difficulty without managing carrying cash credit � Ability to time 

payments to

match cash 

flows 

� Access to 

credit 

� Access to float 

� Use of bonus 

features 

Merchants � Sells goods � Access to large � Need to pay 

and services number of interchange

consumers fees on sales to 

� Ability to sell to cardholders 

consumer � Loss of private 

needing credit credit accounts 

without (customer 

carrying credit loyalty, 

risk marketing � Guaranty of information, 

payment interest 

income) 

Issuing Bank � Collects � Ability to � Operational 

payments from collect on costs 

cardholders interest rate � Fraud risk � Extends credit spreads � Credit risk 

to cardholders � Ability to � Distributes collect 

cards fees from 

� Finances cardholders 

receivables � Ability to share 

� Authorizes in interchange 

transactions fees from 

merchants 

� Ability to crosssell to 

consumers 

Acquiring � Issues � Shares in � OperationaI 

Bank payments to interchange costs 

merchant fees from � Some fraud risk � Routes merchants 

information 

enabling

authorization, 

billing, and 

payment to

merchant 

Card � Promotes the � Collects � Marketing 

Association brand transaction costs � Establishes fees � Cost of fraud 

rules, � Collects reduction 

standards and assessment programs protocols fees � Operational governing costs of participation in maintaining network 

� network Sets 

interchange fee 

structure 

Source: Federal Deposit Insurance Corporation 

them,26 and in 2003 an estimated 60 percent of credit card spending was attributed 

to cards with rewards.27 Card issuers are 

funding these increasingly popular reward 

programs through interchange fees. 

Outside the United States, Visa and MasterCard have come under additional pressures 

to reduce interchange fees. Regulators in 

Australia, the European Union, Israel, and 

the United Kingdom, among others, have 

reviewed the effects of interchange fees on 

competition. Overseas, Visa and MasterCard have been pressured to reduce these 

fees.28 

Significant Litigation against Visa and 

MasterCard and Its Aftereffects 

As indicated above, when Visa and MasterCard were building their dominant credit 

card networks, they imposed exclusionary 

rules and restrictions on other parties to 

credit card transactions. In two cases, whose 

outcomes are described in this section, merchants and the U.S. Department of Justice 

(DOJ) successfully challenged some of these 

practices. The decisions in the two cases29 

weakened some barriers to competition and 

reduced the control exercised by the card 

associations, thus influencing the future of 

the credit card industry. In fact, the aftereffects of the decisions have already begun 

appearing. 

26 The lower estimate is from Swartz et al. (2004), and the higher 

estimate is from Wong (2004b).
 

27 Wong (2004b).
 

28 These efforts are criticized by Swartz et al. (2004) for not
 

considering the benefits to all parties of payment card usage, and
 

by Schmalensee (2001) for not considering the proper role of
 

interchange fees.
 

29 They are: United States v. VISA U.S.A., Inc., 163 F.Supp.2d 322
 

(S.D.N.Y., 2001) (original decision), with final decision in United
 

States v. VISA U.S.A., Inc., 344 F.3d 229 (2d Cir. 2003) and In re
 

VISA Check/Mastermoney Antitrust Litigation, 287 F.Supp.2d 503
 

(E.D.N.Y. 2003) (original decision), with final decision in Wal-Mart 

Stores, Inc. v. VISA U.S.A., Inc., 396 F.3d 96 (2d Cir. 2005). The 

second case is commonly known as the ‘Honor-All-Cards’ case. 

2005, VOLUME 17, NO. 3 29 FDIC BANKING REVIEW 
Overview of Recent Developments in The Credit Card Industry 

Successful Legal Challenges 

One case dealt with restrictions on banks’ ability 

to issue cards that competed with Visa and MasterCard. The other related to a requirement forcing 

merchants to accept all types of MasterCard and 

Visa payment cards regardless of the fees associated 

with those transactions. 

The decision in the first case prohibited Visa and 

MasterCard from banning member banks from 

issuing cards on rival networks. This litigation 

ended in October 2004, when the U.S. Supreme 

Court refused to hear an appeal of the case. The 

case began in October 1998 when the DOJ 

claimed that Visa and MasterCard, by not allowing 

their member banks to issue credit cards on other 

networks (including American Express and Discover Card), were limiting competition in the 

credit card market and therefore violating the 

Sherman Antitrust Act.30 

The second case illustrated merchants’ unwillingness to accept conditions and costs unilaterally 

imposed on them by the card associations. Some of 

the largest U.S. merchants—including Wal-Mart 

Stores Inc. (Wal-Mart), Sears,, and Safeway Inc.— 

joined forces to battle rules imposed on them by 

MasterCard and Visa. These rules required the 

merchants to accept for payment any card that had 

the Visa or MasterCard logo. Merchants challenged the “Honor All Cards” rule because certain 

types of cards—namely, signature debit cards—had 

significantly higher processing fees than PIN debit 

cards, and merchants had no role in establishing 

these fees. Merchants argued that fees should be 

established in some proportion to the risks that the 

transaction poses to the network. As part of a 

2003 settlement, Visa and MasterCard agreed to: 

pay retailers collectively $3 billion over ten years, 

temporarily reduce debit card fees, permanently 

change the “Honor All Cards” policy as it relates 

to debit cards, and establish lower transaction 

fees.31 The settlement did not address requirements for merchants to accept premium credit 

cards.32 

The primary significance of these cases is that merchants have become a much stronger bargaining 

partner in negotiations over the responsibilities 

and fees associated with credit card transactions. 

Merchants are no longer likely to tolerate quietly 

what they view as uncompetitive practices or 

unreasonable fees imposed on them by the card 

associations. One can assume, therefore, that the 

long and costly battle with Visa and MasterCard 

has not ended. Because sizeable segments of the 

merchants’ customer base will want to use credit 

cards for payment, retailers will continue to have 

difficulty refusing to accept them, but by pursuing 

alliances with Visa and MasterCard’s competitors 

and by encouraging their customers to use cards 

with lower merchant fees, merchants may find it 

easier to win cost concessions. 

The Aftereffects: Recent Business 

Alliances and Developments 

Already, merchants’ freedom to refuse certain 

higher-fee cards and banks’ freedom to issue any 

type of credit card have generated new alliances in 

the reinvigorated credit card industry. Some important deals have since taken place in the wake of 

the resolution of these cases. It remains to be seen 

how successful these new partnerships will be. 

American Express cards, marketed mostly to 

wealthy customers on the basis of the cards’ superior rewards program, are now offered by banks that 

were previously prohibited from offering those 

cards. In January 2004, MBNA became the first 

major issuer of Visa and MasterCard in the United 

States to offer American Express as an option to its 

30 After the final disposition of this case, both American Express and Discover 

filed lawsuits against Visa and MasterCard for unspecified damages. 

31 On April 30, 2003, MasterCard settled the dispute. Terms of the 

settlement included agreements to (1) pay retailers about $1 billion over ten 

years, (2) reduce the debit card fees it charges retailers, (3) change its 

“Honor All Cards” policy beginning in January 2004 by giving retailers the 

choice of accepting either online or offline debit cards, and (4) establish a 

separate interchange rate for its debit transactions (previously it had blended 

credit and debit transactions into a single interchange rate), reducing the 

interchange rate for its debit transactions by at least one-third. Visa’s 

settlement agreement contained similar terms, some of which were that Visa 

would (1) pay retailers $2 billion over ten years starting in 2004; (2) modify 

its “Honor All Cards” rule so that beginning in 2004 merchants may accept 

Visa check card only, Visa credit card only, or both; and (3) lower its fees for 

certain types of merchants. 

32 Premium cards are a type of credit card typically targeted to more affluent 

customers that have more rewards and higher interchange fees. 

FDIC BANKING REVIEW 30 2005, VOLUME 17, NO. 3 
 

Overview of Recent Developments in the Credit Card Industry 

customers;33 Citigroup Inc. followed suit in 

December 2004,34 and USAA Federal Savings 

Bank in May 2005.35 In addition, a dual-branded 

American Express and Visa card (a charge card for 

American Express, a credit card for Visa) that provides a consolidated rewards program is anticipated 

to be offered by UBS in late 2005.36 

Another dual-branded card was announced by 

MasterCard and the much smaller Diners Club. 

Diners Club will reissue its cards to include the 

MasterCard number and to carry both the Diners 

Club and MasterCard brand marks, with the cards 

processed as MasterCard transactions in North 

America but continuing to receive the much superior Diners Club rewards. This deal creates more 

transactions on the MasterCard system enabling 

greater economies of scale. It also may bring additional cardholders and merchants into the MasterCard system.37 Diners Club and its cardholders 

benefit because the card now will be accepted at 

almost three times as many merchants.38 

Discover also announced some potentially important deals. In January 2005, Discover announced 

plans with Wal-Mart and GE Consumer Finance 

(a unit of General Electric Company) to launch a 

new credit card on the Discover network.39 WalMart will benefit from this arrangement because 

the arrangement is structured in a way that enables 

the merchant to avoid paying interchange fees on 

any transactions made on that card on the merchant’s own premises. GE Consumer Finance, the 

issuer for many large retailers’ private credit cards, 

will issue the card—the first time that an entity 

other than Discover has issued one of Discover’s 

cards. Should the Wal-Mart–Discover Card product prove successful, Discover may be able to persuade other stores to create similar products, 

thereby extending the size of its cardholder base. 

However, this arrangement will not provide Discover with much revenue on card transactions. 

Earlier, in November 2004, Discover acquired the 

Pulse EFT Association for $311 million. Pulse is 

the third-largest PIN debit network in the country 

and had been owned by the more than 4,000 

financial institutions that were its members, with 

90 million debit cardholders.40 Discover’s acquisition of Pulse provided Discover not only with a 

debit product but also possibly with a greater 

opportunity to market its credit card product to 

Pulse’s member financial institutions or directly to 

their customers. 

Consolidation among credit card issuers has 

increased. During a four-month period in 2005, 

the three largest monoline credit card banks— 

MBNA,41 Capital One Financial Corporation 

(Capital One),42 and Providian43 (the third, fifth, 

and seventh largest credit card issuers, respectively)—all announced transactions that signaled significant changes in the structure of credit card 

issuers. MBNA is being acquired by Bank of 

America, and Providian is being acquired by 

Washington Mutual. In a mirror image of these 

transactions, Capital One is purchasing Hibernia 

Corporation, the holding company for a regional 

bank. 

These transactions will affect the structure of the 

credit card issuer market. Bank of America now 

will become the largest issuer. Upon completion 

of each of these deals, the largest ten issuers will 

control 90 percent of the market. Greater concentration among card issuers also means that a smaller number of banks will control the card 

associations. 

33 American Express (2004a).
 

34 American Express (2004b).
 

35 American Express (2005b).
 

36 American Express (2005a).
 

37 Diners Club (2004) and MasterCard Inc. (2004).
 

38 Lieber (2005).
 

39 Wal-Mart (2005).
 

40 Discover Financial (2004).
 

41 Bank of America (2005).
 

42 Capital One (2005).
 

43 Washington Mutual (2005).
 

2005, VOLUME 17, NO. 3 31 FDIC BANKING REVIEW 
Overview of Recent Developments in The Credit Card Industry 

Conclusion: Challenges Facing the 

U.S. Credit Card Industry Today 

The challenges facing the U.S. credit card industry 

are substantial. The largest U.S. merchants are 

now better able to negotiate lower interchange 

rates from all networks and may pressure other participants in the credit card transaction to lower 

costs. They could also develop innovative 

arrangements to retain a greater portion of the revenue stream. Additionally, other merchants are 

attempting to replicate these efforts. If successful, 

these developments could lead to a decline in pricing flexibility for the interchange rate structure on 

which the multiple card issuer networks are based. 

At the same time, Visa and MasterCard’s smaller 

competitors—Discover (the smallest of the major 

card networks) and American Express—are facing 

challenges of their own. As noted above, Discover 

has made moves that may give it access to the 

debit card market and opportunities to increase its 

cardholder base; alliances with other large retailers 

eager to reduce interchange fees may follow. Hindering Discover’s efforts are lack of an international presence, limitations associated with its less 

affluent customer base, and its small number of 

cardholders and merchants. The future of Discover is largely dependent upon the objectives of its 

parent company. Management of Discover’s parent company, Morgan Stanley, and decisions about 

Discover’s continuing corporate relationship with 

Morgan Stanley have been uncertain since early 

2005, impeding Discover’s ability to develop and 

execute a clear business strategy for its own future. 

American Express has made progress in increasing 

its cardholder base.44 However, it is facing new 

competition for its higher net worth customers 

from MasterCard’s World and Visa’s Signature programs, both of which offer higher rewards than 

their traditional programs. The World and Signature programs charge interchange rates that are 

lower than those of American Express but higher 

than the two card associations’ other programs.45 

American Express may therefore find it hard to 

maintain high fees, at least with some larger merchants. Finally, greater numbers of consumers are 

expecting rewards with their card use. 

The industry is also facing serious challenges from 

credit card fraud, identity theft, and the need to 

secure confidential information. These challenges 

have always been an operational risk, but the problem has intensified now that large quantities of 

confidential information are maintained in Internet-accessible systems and criminals are becoming 

more sophisticated in obtaining and using sensitive 

data. Besides being a costly drain on banks, these 

problems have the potential to erode consumer 

confidence in the credit card industry. Consumers’ 

concerns about the security of credit cards and 

confidential information need to be addressed. 

Otherwise, consumers may become reluctant to 

continue using credit cards as freely as they do 

now.46 

Consumers’ growing sophistication in the use of 

their credit cards goes beyond their greater awareness of fraud issues. An important element of the 

business model of credit card issuers is interest 

income. However, increasing numbers of cardholders—an estimated 55 percent of them—are 

“convenience users,” paying their balances in full 

each month to avoid interest charges.47 On the 

other hand, others are having difficulty managing 

the use of their cards, incurring debt potentially 

beyond their means to repay and representing 

credit risk to card issuers. 

44 However, it is unclear whether Bank of America, after its acquisition of
 

MBNA, will implement MBNA’s previous decision to issue American Express
 

cards.
 

45 Mason (2005).
 

46 Both Visa and MasterCard have recently instituted zero-liability policies in
 

an effort to combat these concerns. Visa states: “Use your Visa card to shop
 

online, in a store, or anywhere, and you’re protected from unauthorized use
 

of your card or account information. With Visa’s Zero Liability policy, your
 

liability for unauthorized transactions is $0—you pay nothing.” MasterCard
 

states: “As a MasterCard cardholder you are not liable in the event of an
 

unauthorized use of your U.S.-issued MasterCard card. This coverage extends
 

to purchases made in a store, over the telephone, or online.”
 

47 Aizcorbe, Kennickell, and Moore (2003).
 

FDIC BANKING REVIEW 32 2005, VOLUME 17, NO. 3 
Overview of Recent Developments in the Credit Card Industry 

In short, the highly competitive credit card industry is in flux. Credit card associations, controlled 

by a diminishing number of large card issuers, are 

caught between cardholders seeking greater 

rewards and merchants trying to lower the cost of 

accepting payments. At the same time, the card 

associations are not only incurring increasing 

expenses because of fraud and fraud prevention but 

they are also bearing the costs of recent and pending litigation. For decades it was not hard to envision what the credit card industry would look like 

five years into the future. This is no longer true. 

2005, VOLUME 17, NO. 3 33 FDIC BANKING REVIEW 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Overview of Recent Developments in The Credit Card Industry 

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U.S. Family Finances: Evidence from the 1998 and 2001 Survey of Consumer 

Finances. Federal Reserve Bulletin (January): 1–32. 

American Banker Online. 2005. In Brief: Restaurant Group Joins Protest. May 20. 

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Press Release January 29. www.americanexpress.com. [July 22, 2005]. 

———. 2004b. American Express Announces Card Issuing Alliance with Citibank. Press 

Release December 13. www.americanexpress.com. [August 8, 2005]. 

———. 2005a. UBS Selects American Express, Juniper Bank, and Visa to Provide Its DualCard Program with Consolidated Rewards for UBS Wealth Management USA 

Clients. Press Release April 18. www.americanexpress.com. [August 8, 2005]. 

———. 2005b. American Express and USAA Announce Card-Issuing Alliance. Press 

Release May 31. www.americanexpress.com. [August 8, 2005]. 

Bank of America. 2005. Bank of America to Acquire MBNA. Press Release June 30. 

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Capital One. 2005. Capital One to Acquire Hibernia Corporation for $5.3 Billion in Stock 

and Cash. Press Release March 5. www.capitalone.com. [July 22, 2005]. 

Chakravorti, Sujit. 2003. Theory of Credit Card Networks: A Survey of the Literature. 

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Day, Kathleen, and Caroline E. Mayer. 2005. Credit Card Penalties, Fees Bury Debtors. 

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Kissane, Jim, and Kristen J. Duca. 2005. First Data Corp. – Outperform: Western Union 

Improves; Merchant Weakens. Bear Sterns Equity Research. July 17. Bear, Stearns 

& Co. Inc. 

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Vastly Expands Reach; Racking Up Airline Points. The Wall Street Journal, March 30, 

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2005, VOLUME 17, NO. 3 35 FDIC BANKING REVIEW 

 

A Moving-Average Formula for Calculating 

Deposit Insurance Assessments 

by Panos Konstas* 

Current deposit insurance assessment policy is 

largely a product of three laws passed by Congress 

between 1989 and 1996: the Financial Institutions 

Reform, Recovery, and Enforcement Act of 1989 

(FIRREA), the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), and 

the Deposit Insurance Funds Act of 1996 (DIFA).1 

FIRREA chiefly addressed the financial crisis facing the thrift industry, but it also made fundamental changes in the deposit insurance assessment 

system. It renamed the FDIC’s deposit insurance 

fund the Bank Insurance Fund (BIF), and it created the Savings Association Insurance Fund 

(SAIF). It also established a statutory minimum 

reserve ratio—called the designated reserve ratio 

(DRR)—of 1.25 percent for both the BIF and the 

SAIF. Two years after passage of FIRREA, 

FDICIA further changed the assessment system: it 

required the FDIC to (1) establish a system of riskbased deposit insurance premiums, (2) impose a 

minimum level of assessments on insured institutions when the reserve ratio is less than the DRR, 

and (3) set semiannual assessments to maintain 

the reserve ratio of each fund at 1.25 percent. Five 

years later still, DIFA enacted further changes, 

eliminating significant differences in the pricing of 

deposit insurance for BIF and SAIF members and 

limiting the FDIC’s ability to charge premiums 

when the reserve ratio is at or above the DRR. 

Thus, since 1996 the BIF and the SAIF have been 

on a pay-as-you-go basis in relation to the ratio of 

each insurance fund’s balance—or net worth—to 

its estimated insured deposits. Should insurance 

costs push the reserve ratio of either fund below 

1.25 percent, the FDIC must either set premiums 

at a level that will bring the fund back to 1.25 percent within one year or set premiums at a minimum of 23 basis points and establish a plan to 

bring the fund back up to a 1.25 percent level 

within 15 years.2 In either the 1-year case or the 

15-year case, insurance losses greater than the 

interest income earned by the BIF or the SAIF will 

result in higher premiums for the banking indus­

* The author is a senior economist in the FDIC’s Division of Insurance and
 

Research. He thanks Christine Blair, Kymberly Copa, Lee Davison, Joe
 

DiNuzzo, Steven Guggenmos, Barry Kolatch, Jack Reidhill, and Munsell St.
 

Clair for their comments and James Lamont for help with the data.
 

1 Financial Institutions Reform, Recovery, and Enforcement Act of 1989, Public
 

Law 101-103; Federal Deposit Insurance Corporation Improvement Act of 1991,
 

Public Law 102-242, and Deposit Insurance Funds Act of 1996, Public Law
 

104-208.
 

2 See footnote 9. 


FDIC BANKING REVIEW 37 2005, VOLUME 17, NO. 3 
A Formula for Calculating Deposit Insurance Assessments 

try—an event that could be a formidable problem 

for banks during periods of financial stress. 

This article examines the level and volatility of 

the assessment rates that would have been imposed 

if the current 1.25 DRR policy had been in effect 

when the FDIC first began operations in 1934. 

Specifically, to get an idea of how high the 

required premiums might have been and how dramatically they might have changed from year to 

year, we calculated BIF assessment rates for the 

1940–1995 period using current law.3 The results 

indicate that if the current law had been in effect 

from 1940 to 1995, assessment rates would have 

swung widely during volatile times, with high 

assessments in some years and low or zero premiums in others, and that in general the policy would 

have imposed high premiums when bank profits 

were weak and low premiums when profits were 

strong. 

We also examined two premium-setting schemes 

that contrast with the current system. The first 

involves deriving the applicable assessment rates to 

maintain the reserve ratio at 1.25 percent on the 

basis of a moving average of previous years’ actual 

BIF outlays for failures and operating costs. This 

approach would smooth the extremes in the high 

assessment rates required under the current policy, 

thus helping the banking industry through cyclical 

fluctuations. However, assessment rates would still 

change almost yearly, and in some years assessment 

rebates would be needed to maintain the reserve 

ratio at 1.25 percent. The second scheme uses the 

same moving-average method, but in addition it 

imposes a minimum positive assessment premium 

in the calculation formula. The advantages of this 

scheme are that assessment rebates would be eliminated by definition and the yearly assessment rate 

would remain relatively stable over long stretches 

of time. But the possibility of very high premiums 

in some years would remain. 

The Development of the Current 

Assessment System 

To give a fuller understanding of the current assessment system, this section discusses the history of 

the reserve ratio, the premium structure, and the 

role played by insurance losses. 

The Reserve Ratio 

Throughout the FDIC’s history the reserve ratio 

has been noticeably stable over long periods, 

although the long-term trend has generally been 

downward. The ratio was at its highest during the 

first ten years of the FDIC’s existence, peaking at 

1.96 percent in 1941. From the mid-1940s to the 

late 1960s the ratio fluctuated between 1.3 and 1.5 

percent, and during the 1970s and early 1980s it 

hovered around 1.2 percent. Then came the 

banking crisis of the 1980s and early 1990s. In 

1989, when the 1.25 percent DRR requirement 

was introduced by FIRREA, the ratio of the BIF to 

estimated insured deposits stood at 0.70 percent 

(see table 1 and figure 1). 

Figure 1 

1934 1938 1942 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 

-0.50 

0.00 

0.50 

1.00 

1.50 

2.00 

2.50 

Source: FDIC Annual Reports 

Historical BIF Reserve Ratios, 1934–1995 

The main events affecting the ratio have been 

statutory changes in the insurance limit and insurance losses from bank failures. In 1974, when 

Congress raised the insurance coverage from 

$20,000 to $40,000, the ratio declined, and it 

declined again in 1980 when the $40,000 limit was 

raised to the current $100,000. It declined further, 

and the fund reserves briefly fell below zero, during 

the aforementioned banking crisis, during which 

the fund had to absorb actual and projected losses. 

3 Although the FDIC manages the BIF and the SAIF, the analysis here focuses 

only on the BIF. 

2005, VOLUME 17, NO. 3 38 FDIC BANKING REVIEW 
A Formula for Calculating Deposit Insurance Assessments 

Table 1 

Data on the FDIC Bank Insurance Fund (Dollar Amounts in Millions) 

Estimated Effective Effective 

Insured BIF BIF Net Assessment Assessment Assessment 

Year Deposits Costs Worth Base Rate (b.p.) Revenue 

BIF 

Ratio 

1995 1,952,543 484 25,453 2,429,200 12.4 2,908 

1994 1,896,060 -2,259 21,848 2,496,000 23.6 5,891 

1993 1,906,885 -6,791 13,122 2,370,615 24.4 5,784 

1992 1,945,623 -626 -101 2,429,478 23.0 5,588 

1991 1,957,722 16,862 -7,028 2,428,471 21.3 5,161 

1990 1,929,612 13,003 4,045 2,379,417 12.0 2,855 

1989 1,873,837 4,346 13,210 2,262,905 8.3 1,885 

1988 1,750,259 7,588 14,061 2,128,451 8.3 1,773 

1987 1,658,802 3,271 18,302 2,036,014 8.3 1,696 

1986 1,634,302 2,964 18,253 1,821,008 8.3 1,517 

1985 1,503,393 1,958 17,957 1,720,768 8.3 1,433 

1984 1,389,874 1,999 16,529 1,586,435 8.0 1,269 

1983 1,268,322 970 15,429 1,458,463 7.1 1,041 

1982 1,134,221 1,000 13,771 1,331,212 7.7 1,024 

1981 988,898 848 12,246 1,247,299 7.1 891 

1980 948,717 84 11,020 1,142,737 3.7 423 

1979 808,555 94 9,793 1,057,623 3.3 352 

1978 760,706 149 8,796 972,509 3.9 374 

1977 692,533 114 7,993 877,911 3.7 325 

1976 628,263 212 7,269 811,645 3.7 300 

1975 569,101 98 6,716 769,868 3.6 275 

1974 520,309 159 6,124 705,162 4.4 307 

1973 465,600 108 5,615 635,534 3.9 245 

1972 419,756 60 5,159 562,785 3.3 187 

1971 374,568 60 4,740 500,840 3.5 173 

1970 349,581 46 4,380 443,337 3.6 158 

1969 313,085 35 4,051 437,215 3.3 146 

1968 296,701 29 3,749 401,561 3.3 134 

1967 261,149 27 3,486 363,866 3.3 121 

1966 234,150 20 3,252 341,297 3.2 110 

1965 209,690 23 3,036 312,725 3.2 101 

1964 191,787 18 2,845 285,954 3.2 92 

1963 177,381 15 2,668 264,826 3.1 83 

1962 170,210 14 2,502 244,178 3.1 76 

1961 160,309 15 2,354 226,771 3.2 73 

1960 149,684 13 2,222 216,567 3.7 80 

1959 142,131 12 2,090 213,926 3.7 79 

1958 137,698 12 1,965 200,240 3.7 74 

1957 127,055 10 1,851 191,236 3.6 68 

1956 121,008 9 1,742 186,675 3.7 69 

1955 116,380 9 1,640 181,873 3.7 67 

1954 110,973 8 1,543 173,109 3.6 62 

1953 105,610 7 1,451 166,507 3.6 59 

1952 101,841 8 1,364 157,263 3.7 58 

1951 96,713 7 1,282 149,220 3.7 55 

1950 91,359 8 1,244 147,539 3.7 55 

1949 76,589 6 1,204 147,299 8.3 123 

1948 75,320 7 1,066 143,217 8.3 119 

1947 76,254 10 1,006 137,335 8.3 114 

1946 73,759 10 1,059 128,451 8.3 107 

1945 67,021 9 929 112,485 8.3 94 

1944 56,398 9 804 97,119 8.3 81 

1943 48,440 10 703 84,034 8.3 70 

1942 32,837 10 617 67,827 8.3 57 

1941 28,249 10 554 61,705 8.3 51 

1940 26,638 13 496 55,462 8.3 46 

1939 24,650 16 453 48,860 8.3 41 

1938 23,121 11 421 45,978 8.3 38 

1937 22,557 12 383 46,579 8.3 39 

1936 22,330 11 343 42,737 8.3 36 

1935 20,158 11 306 13,806 8.3 12 

1934 18,075 10 292 

1.30 

1.15 

0.69 

-0.01 

-0.36 

0.21 

0.70 

0.80 

1.10 

1.12 

1.19 

1.19 

1.22 

1.21 

1.24 

1.16 

1.21 

1.16 

1.15 

1.16 

1.18 

1.18 

1.21 

1.23 

1.27 

1.25 

1.29 

1.26 

1.33 

1.39 

1.45 

1.48 

1.50 

1.47 

1.47 

1.48 

1.47 

1.43 

1.46 

1.44 

1.41 

1.39 

1.37 

1.34 

1.33 

1.36 

1.57 

1.42 

1.32 

1.44 

1.39 

1.43 

1.45 

1.88 

1.96 

1.86 

1.84 

1.82 

1.70 

1.54 

1.52 

1.61 

Mean 569,726 762 5,350 732,805 6.9 763 

Std. Dev 662,395 3,048 6,383 799,699 5.0 1,442 

1.29 

0.39 

Source: FDIC Annual Reports 

FDIC BANKING REVIEW 39 2005, VOLUME 17, NO. 3 
A Formula for Calculating Deposit Insurance Assessments 

The Premium Structure 

At the same time that the reserve ratio has been 

trending downward, the structure of premium 

assessments has been evolving. Until 1989, all 

insured banks paid assessments at a statutory annual flat rate of 1/12 of 1 percent (0.0833 percent, or 

8.33 basis points) of assessable deposits.4 During 

periods when bank failures were rare, the fund kept 

growing. In 1950, the Federal Deposit Insurance 

Act provided for a rebate to banks of a portion of 

their assessments in the form of an assessment 

credit applied toward the amount owed in the following year. Specifically, the rebates—or assessment credits—totaled 60 percent of net assessment 

income (the amount of the FDIC’s annual assessment income in excess of its annual administrative 

expenses and costs of insurance losses).5 For the 

period 1950–1980, in every year but one these 

rebates reduced the effective assessment rate to less 

than half of the statutory rate (see table 1). 

As noted above, FIRREA made several important 

changes in the system of assessments. It increased 

the statutory assessment rate to 0.12 percent in 

1990 and to a minimum of 0.15 percent in 1991, 

and it gave the FDIC additional flexibility to 

adjust assessment rates and pursue reserve targets. 

Specifically, the FDIC would be able to increase 

the assessment rate up to a maximum of 0.325 percent to prevent a decrease in the ratio of the BIF 

to estimated insured deposits. And the FDIC 

would be able to set the DRR as high as 1.50 percent if that high a ratio was deemed necessary to 

meet a risk of substantial future losses to the BIF.6 

Subsequently, high actual and projected losses to 

the BIF caused the assessment rate for banks to 

increase sharply, reaching 0.23 percent (23 basis 

points) in 1993. 

In January 1993, as required by FDICIA, the FDIC 

implemented a system of risk-based deposit insurance premiums. Under the system, deposit insurance assessments are based on the financial 

soundness of the institution and the level of risk 

that it poses to the deposit insurance funds.7 

Specifically, risk-based premiums are determined 

on the basis of capital and supervisory ratings: the 

capital rating provides an objective, numerical 

standard, and the supervisory rating incorporates 

examination results and other risk-related information.8 FDICIA required the risk-based system to 

charge an average annual assessment rate of 23 

basis points until the BIF was recapitalized.9 The 

original assessment schedule implemented in 1993 

(shown in table 2) had a rate spread of 8 basis 

points: the best-rated institutions were charged 23 

basis points and the riskiest institutions were 

charged 31 basis points. The effective or average 

annual assessment rate in 1993 was 0.244 percent, 

or 24.4 basis points. 

After the BIF reserve ratio reached the DRR in 

mid-1995, the FDIC began to lower BIF assessment rates in order to maintain the reserve ratio at 

1.25 percent. Accordingly, the average assessment 

rate for the second half of 1995 declined from 23.2 

points (a matrix spread of 23 to 31 basis points) to 

4.4 basis points (a matrix spread of 4 to 31 basis 

points). In 1996, the assessment rate schedule was 

again lowered, so that the best-rated institutions 

were charged nothing, and the riskiest institutions 

were charged 27 basis points. Because the BIF 

reserve ratio remains above 1.25 percent, the FDIC 

continues to use this rate schedule today (see table 

2). 

4 Deposit insurance premiums are assessed against total domestic deposits
 

(demand deposits and time and savings deposits), adjusted for items such as
 

float. 


5 See Christopher (1978).
 

6 See Konstas (1992) for details.
 

7 FDICIA requires the FDIC to set risk-based deposit insurance rates
 

independently for the BIF and the SAIF.
 

8 The capital measures are consistent with the prompt corrective action
 

requirements of FIRREA.
 

9 Under FDICIA, when the reserve ratio of the BIF falls below 1.25 percent, as
 

it did before May 1995, the FDIC is given two alternatives: it can impose
 

semiannual assessment rates to generate sufficient revenue to raise the BIF
 

ratio to the designated target within a year after such rates have been set, or
 

it can promulgate through regulation a schedule of assessment rates (for a
 

period of up to 15 years) that would return the fund to the designated 1.25
 

percent reserve goal. When the second option is selected, the FDIC is
 

required to set assessment rates for members in accordance with a time
 

schedule that specifies, at semiannual intervals, target reserve ratios for the
 

BIF, culminating in attainment of the designated ratio within 15 years. Under
 

this second option, the statute explicitly directs the FDIC to set rates that will
 

at a minimum generate revenue equivalent to the amount generated by the
 

assessment rate in effect on July 15, 1991 (when an assessment rate of 23
 

basis points applied), as long as the BIF ratio remains below 1.25 percent.
 

Under the second option, therefore, if the reserve ratio falls below 1.25
 

percent, the minimum premium that can be charged to the industry for
 

restoring the reserve ratio to the DRR is 23 basis points.
 

2005, VOLUME 17, NO. 3 40 FDIC BANKING REVIEW 
A Formula for Calculating Deposit Insurance Assessments 

Table 2 

Risk-Based Deposit Insurance Rate Schedule, 

1993 and 2005 

1993 (Original) Rate Matrix (basis points) 

Supervisory Risk Subgroup 

Capital Group A B C 

1. Well capitalized 23 26 29 

2. Adequately capitalized 26 29 30 

3. Undercapitalized 29 29 31 

2005 (Current) Rate Matrix (basis points) 

Supervisory Risk Subgroup 

Capital Group A B C 

1. Well capitalized 0 3 17 

2. Adequately capitalized 3 10 24 

3. Undercapitalized 10 24 27 

Source: FDIC Quarterly Banking Profile. 

Insurance Losses 

Obviously, the size of the assessments that must be 

imposed on banks is determined largely by insurance losses, for when losses occur they are often a 

major expense item on the BIF’s income statement. During the banking crisis of the 1980s and 

early 1990s, insurance losses increased dramatically. Losses through 1983 had amounted to less than 

$1 billion per year, but in 1984 they more than 

doubled, exceeding assessment income. As a 

result, assessment credits were no longer feasible.10 

Losses rose to $7.4 billion in 1988, and for the first 

time in its history the FDIC experienced a net 

operating loss. In 1991, estimated losses from 

banks that regulators had identified as either equity insolvent or likely to become equity insolvent in 

the foreseeable future rose to $16.3 billion—a 

record high.11 

The losses during this period occurred against a 

backdrop of premium increases for insured institutions and far-reaching deposit insurance reform 

legislation. These developments, coupled with a 

recorded BIF deficit of $7.0 billion in 1991, raised 

new concerns not only about the viability of the 

deposit insurance system but also about the operating policies of both the FDIC and insured institutions. 

The Implications of Assessing under the
 

Designated Reserve Ratio of 1.25 Percent
 

The current policy reflects two distinct types of 

problems. The first is reflected in the requirement 

that the ratio of the BIF to estimated insured 

deposits must be at least 1.25 percent. In fact 

there is no widely accepted method of determining 

the optimum size of the BIF, either in terms of an 

absolute amount or in relation to some measure of 

exposure. The BIF has to be sufficient to cover 

losses and meet cash needs. Beyond that, its proper size depends on the contingencies the BIF is 

expected to handle and on the public’s perception 

of the FDIC’s ability to meet its obligations under 

alternative economic scenarios. If the public is 

satisfied with the prospects for the economy and 

the banking industry, a 1.25 percent BIF ratio may 

seem entirely adequate. The same ratio, however, 

may look less than adequate when the economy 

and banks’ prospects worsen. 

The second type of problem is reflected in the 

requirement that premium assessments on banks 

be set at whatever amounts are necessary to keep 

the BIF ratio at some given level. In fact (and not 

surprisingly), for the banking industry high failure 

rates and low profits tend to occur concurrently. 

Thus, when higher assessment premiums are 

required under the current policy, they are likely to 

be charged when many banks are least able to 

afford them. The problem is, of course, compounded if the assessment revenue that must be 

raised in a given year must also be allocated among 

banks according to each bank’s risk status. Highrisk banks then will be subjected to higher costs 

when they can least afford it in terms of both their 

low profitability and their disadvantage compared 

with competitors designated as better risks. Under 

these conditions, a premium structure with the 

10 1983 was the last year that the FDIC provided assessment credits. In 

1991, FDICIA removed the FDIC’s authority to provide rebates of any kind. 

11 However, the large number of failures forecast in 1991 did not occur, so for 

1992, 1993, and 1994, loss reserves of $1.2 billion, $7.3 billion, and $2.7 

billion were added back into the BIF (see Federal Deposit Insurance 

Corporation, Annual Report for cited years). 

FDIC BANKING REVIEW 41 2005, VOLUME 17, NO. 3 
 

A Formula for Calculating Deposit Insurance Assessments 

flexibility to deal with the varying loss situations 

over time becomes a necessity. 

To see the effects of the current rules, we have 

applied the current statutory requirement to maintain the BIF reserve ratio at the 1.25 percent DRR 

to annual data for the period 1940–1995. In any 

given year, the assessment revenue necessary to 

maintain the BIF at the DRR is a function of three 

independent variables: BIF costs (actual and 

anticipated failure losses plus operating expenses), 

growth in insured deposits, and interest earnings 

on the BIF portfolio. The reserve ratio is defined 

as the BIF’s net worth as of a given date divided by 

the amount of estimated insured deposits at that 

date. The equation for the revenue for year t is 

Assessment Revenuet = BIF Costst + 

0.0125(Insured Depositst – 

Insured Depositst–1) – 

BIF Net Wortht–1(Interest Ratet

) 

This equation shows that, for a given year, the 

FDIC must raise enough assessment revenue so 

that the combined amount of assessment revenue 

and investment income will prove sufficient to 

cover BIF costs plus the designated portion (1.25 

percent) of the change in insured deposits during 

the year. This ensures that the BIF reserve ratio at 

the end of the year will remain at the 1.25 percent 

DRR. For the simulation, it has been assumed that 

all of the BIF’s net worth is invested in U.S. securities, where it earns interest at the Treasury 10-year 

bond rate.12 

The results of simulation over the 1940–1995 period are shown in table 3. As indicated on the left 

side of the table, the 1.25 percent ratio can be 

maintained only if the FDIC is able to rebate premiums in no fewer than eight years during the 

period. But under current law no rebates are 

allowed; thus the least amount of assessment that 

the FDIC may put into effect in any one year is 

zero. 13 

The right side of table 3 shows the results of a simulation for 1940–1995 that included no rebates 

and a zero minimum assessment regime. These 

conditions comply with the no rebate requirement, 

but they also necessitate some major deviations 

from the 1.25 DRR target. At the end of 1994 and 

1995, for example, BIF ratios would have reached 

over 2 percent. Note that in 1988, 1990, and 

1991, this simulation results in required assessment 

rates that are well above those actually imposed at 

the time (see tables 1 and 3). 

As shown in the right side of table 3, if the current 

1.25 DRR policy had been implemented in 1940, 

the assessment rate necessary to cover losses, operating expenses, and the fraction of the change in 

insured deposits for that year would have amounted to 5.6 basis points. From then until the late 

1980s the necessary assessment rates would have 

remained generally at manageable levels. After 

that, however, assessment rates would have skyrocketed: 32.3 basis points for 1988, 17.7 points for 

1989, and 49.0 and 62.8 points for 1990 and 1991 

(again, well over two-and-a-half times the actual 

assessment rate applied in either year). The practical effects of levying such assessments on the 

industry could have been severe. A 49 basis point 

assessment in 1990 and a 62.8 point levy in 1991, 

for example, would have meant accrued costs for 

banks equal to about 75 percent of 1990 profits 

and 85 percent of 1991 profits. 

The current policy of maintaining the 1.25 DRR 

poses another problem for the banking industry 

besides occasional very high assessments. The policy requires the rate of assessment to change frequently and swing widely. For example, under the 

zero minimum assessment (or no rebate) regime, 

the assessment rate declines from 62.8 basis points 

to zero basis points between 1991 and 1992. Such 

volatility is a problem because changes in the 

assessment rate affect bank income and net inter12 In practice, the BIF is invested in both long- and short-term Treasuries, 

according to FDIC investment policies. This investment structure allows 

the fund to maintain liquidity for resolving failed banks but still generates 

some income to keep the fund balance at or above the DRR. 

13 The FDIC’s current proposals for deposit insurance reform include giving 

the FDIC Board authority to implement surcharges, rebates and credits as 

needed to maintain the reserve ratio around the 1.25 percent level. For 

more information, see 

www.fdic.gov/news/news/speeches/chairman/spmar1705.html. 

2005, VOLUME 17, NO. 3 42 FDIC BANKING REVIEW 
A Formula for Calculating Deposit Insurance Assessments 

Table 3 

Application of Present (1.25 DRR) Policy (Dollar Amounts in Millions) 

No Assessment Minimum (Rebates) Zero Assessment Minimum (No Rebates) 

Required Required 

Assessment BIF Assessment Assessment BIF Assessment 

Year Rate (b.p.) Ratio Income ($) Rate (b.p.) Ratio Income ($) 

1995 –2.1 1.25 –505 0.0 2.19 0 

1994 –16.7 1.25 –4,161 0.0 2.13 0 

1993 –37.3 1.25 –8,842 0.0 1.86 0 

1992 –10.8 1.25 –2,617 0.0 1.39 0 

1991 62.8 1.25 15,245 62.8 1.25 15,245 

1990 49.0 1.25 11,653 49.0 1.25 11,652 

1989 17.7 1.25 4,014 17.7 1.25 4,013 

1988 32.3 1.25 6,870 32.3 1.25 6,869 

1987 8.9 1.25 1,812 8.9 1.25 1,811 

1986 16.9 1.25 3,070 16.9 1.25 3,070 

1985 8.8 1.25 1,509 8.8 1.25 1,508 

1984 10.2 1.25 1,618 10.2 1.25 1,617 

1983 7.6 1.25 1,109 7.6 1.25 1,108 

1982 9.8 1.25 1,305 9.7 1.25 1,290 

1981 –1.4 1.25 -176 0.0 1.26 0 

1980 6.5 1.25 743 6.4 1.25 728 

1979 –1.3 1.25 -139 0.0 1.27 0 

1978 3.3 1.25 318 3.3 1.25 318 

1977 4.1 1.25 363 4.1 1.25 362 

1976 5.8 1.25 470 5.8 1.25 469 

1975 3.3 1.25 253 3.3 1.25 253 

1974 6.2 1.25 436 6.2 1.25 436 

1973 5.5 1.25 351 5.5 1.25 350 

1972 6.4 1.25 361 6.4 1.25 361 

1971 2.4 1.25 122 2.4 1.25 122 

1970 5.5 1.25 244 5.5 1.25 244 

1969 0.3 1.25 13 0.3 1.25 13 

1968 7.5 1.25 302 7.5 1.25 302 

1967 6.1 1.25 223 6.1 1.25 223 

1966 6.0 1.25 204 6.0 1.25 203 

1965 4.7 1.25 146 4.7 1.25 146 

1964 3.7 1.25 106 3.7 1.25 106 

1963 0.7 1.25 20 0.7 1.25 20 

1962 2.4 1.25 58 2.4 1.25 58 

1961 3.3 1.25 75 3.3 1.25 75 

1960 1.6 1.25 36 1.6 1.25 36 

1959 –0.1 1.25 –3 0.0 1.25 0 

1958 4.5 1.25 90 4.5 1.25 90 

1957 1.7 1.25 33 1.7 1.25 33 

1956 1.2 1.25 22 1.2 1.25 22 

1955 2.0 1.25 36 2.0 1.25 36 

1954 2.3 1.25 39 2.3 1.25 39 

1953 0.9 1.25 14 0.9 1.25 14 

1952 2.5 1.25 40 2.5 1.25 39 

1951 3.0 1.25 44 3.0 1.25 44 

1950 11.5 1.25 170 11.5 1.25 170 

1949 0.4 1.25 6 0.4 1.25 6 

1948 –1.7 1.25 -24 0.0 1.28 0 

1947 1.9 1.25 26 1.9 1.25 26 

1946 6.4 1.25 82 6.4 1.25 82 

1945 11.6 1.25 131 11.6 1.25 131 

1944 10.0 1.25 97 10.0 1.25 97 

1943 23.4 1.25 197 23.4 1.25 197 

1942 8.9 1.25 61 8.9 1.25 61 

1941 3.8 1.25 24 3.8 1.25 24 

1940 5.6 1.25 31 5.6 1.25 31 

Mean 6.1 1.25 674 7.3 1.30 967 

Std. Dev 13.2 0 3,080 11.1 0.19 2,678 

FDIC BANKING REVIEW 43 2005, VOLUME 17, NO. 3 
A Formula for Calculating Deposit Insurance Assessments 

est margins, much as changes in the cost for borrowed funds do.14 

The two main reasons for the wide swings in the 

assessment rate required under the DRR are that 

BIF costs are highly correlated with the state of the 

economy (as mentioned above) and that estimating future bank failures and future BIF losses from 

those failures cannot be done with great precision. 

Under generally accepted accounting principles 

(GAAP), which the FDIC is required to follow, 

losses on bank failures projected to occur within 

the next year, must be recognized when these losses are “estimable and probable.” Such losses can 

not always be calculated accurately. In the early 

1990s, when estimated failures dramatically 

increased, large loss reserves were charged to the 

fund, but when the economy rapidly improved and 

the projected failures did not arrive, the loss 

reserves had to be reversed. As a result, BIF 

reserves and the reserve ratio swung dramatically 

in the 1991–1994 period. 

The Moving-Average Alternative 

An alternative to the current assessment system is 

one in which the annual assessment is based on a 

moving average of past years’ BIF costs, including 

the necessary adjustment for the change in insured 

deposits. Unlike the current system, which raises 

assessment income as necessary to maintain the 

BIF ratio at 1.25 percent, the moving-average 

(MA) alternative would raise income according to 

a fixed formula that would allow the BIF ratio to 

achieve the 1.25 percent level over a span of time. 

Because of averaging, such a system would tend to 

reduce the extreme variability in annual premiums. 

When BIF costs were rising, banks in a given year 

would be assessed at a lower rate than the rate necessary to cover actual or anticipated BIF costs, and 

the observed BIF ratio for the year would tend to 

decline. This would occur when actual costs were 

rising, as happened during the 1980s. The reverse 

would be true when costs were falling: in years 

when actual costs were falling, as happened in 

1979 and 1980, the assessment raised under the 

MA method would tend to exceed the BIF costs 

incurred. 

We can simulate the MA method by using the BIF 

statistics contained in table 1. We derived fourand six-year moving-average calculations for 

assessment revenues and other data starting with 

1940. For the four-year average, we determined 

the assessment for a given year by summing up the 

BIF costs (insurance losses plus operating expenses) and the insured-deposits growth factor of the 

previous four years, dividing the total by four, and 

subtracting from the quotient the amount of 

investment income earned by the BIF during the 

year. For example, to calculate the premium for 

1940 we summed up the actual BIF costs and 

insured-deposit reserve factors (annual dollar 

change in insured deposits times 0.0125) for 1939, 

1938, 1937, and 1936; divided the resultant total 

by four; and subtracted from this number the 

income earned on the investment of the BIF balance in 1940 (year-end 1939 BIF net worth times 

the interest rate for 1940). 

This approach avoids most of the problems mentioned above associated with the present 1.25 

DRR method. As shown in table 4 and figure 2, 

both the four- and the six-year MA methods produce assessment-rate and assessment-income 

14 From the standpoint of a bank, a 25 basis point increase in the 

assessment rate is the same as a one-quarter of 1 percent increase in the 

interest rate for deposit funds. This type of change, whether in the 

assessment rate or in the interest rate, makes it more costly for a bank to 

carry and continue refinancing long-term assets, such as home mortgages. 

Figure 2 

1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 

-30 

-20 

-10 

0 

10 

20 

30 

40 

50 

60 

70 

Basis Points 

4-Year MA 

6-Year MA 

1.25 DRR 

Note: The 1.25 DRR calculation uses a zero-assessment minimum; neither the small 

negative assessment rates that would have occurred in 1948, 1959, 1979, and 1981, 

nor the significant negative assessment rates that would have occurred from 1992-1995, 

are shown. 

Assessment Rate Comparison: 

Moving Average Methods vs. Current 

(1.25 DRR) Method, 1940–1995 

2005, VOLUME 17, NO. 3 44 FDIC BANKING REVIEW 
A Formula for Calculating Deposit Insurance Assessments 

Table 4 

Application of Moving Average Method (Dollar Amounts in Millions) 

4-year Moving Average 6-year Moving Average 

Required Required 

Assessment BIF Assessment Assessment BIF Assessment 

Year Rate (b.p.) Ratio Income ($) Rate (b.p.) Ratio Income ($) 

1995 –16.1 1.26 –3,913 –1.7 1.41 –425 

1994 –17.5 1.42 –4,360 8.2 1.40 2,050 

1993 2.1 1.42 492 15.9 1.09 3,779 

1992 19.7 0.96 4,793 24.9 0.49 6,049 

1991 30.3 0.63 7,365 29.3 0.14 7,122 

1990 39.9 1.04 9,484 31.9 0.59 7,598 

1989 28.4 1.16 6,421 24.4 0.83 5,514 

1988 18.3 1.03 3,904 16.6 0.75 3,527 

1987 17.2 1.21 3,499 15.4 0.95 3,138 

1986 12.9 1.11 2,352 12.4 0.90 2,263 

1985 10.7 1.16 1,835 9.5 0.95 1,638 

1984 8.3 1.14 1,324 6.8 0.95 1,085 

1983 8.0 1.16 1,161 6.2 0.99 909 

1982 5.3 1.16 700 3.2 1.00 420 

1981 1.9 1.21 242 1.1 1.08 139 

1980 1.2 1.17 140 1.3 1.06 148 

1979 3.1 1.24 327 2.9 1.12 309 

1978 2.5 1.18 241 2.8 1.07 268 

1977 4.2 1.19 368 4.3 1.07 379 

1976 4.8 1.19 393 4.6 1.06 374 

1975 4.8 1.20 369 4.1 1.07 313 

1974 4.6 1.17 326 3.8 1.06 270 

1973 4.9 1.19 313 4.0 1.08 254 

1972 5.1 1.20 289 4.4 1.10 247 

1971 3.9 1.21 195 4.2 1.11 211 

1970 3.3 1.19 145 3.4 1.09 151 

1969 4.2 1.22 184 3.8 1.11 167 

1968 4.6 1.17 186 3.9 1.06 157 

1967 5.9 1.20 216 4.4 1.10 159 

1966 4.8 1.20 165 3.5 1.11 118 

1965 3.8 1.22 120 3.2 1.14 100 

1964 2.8 1.23 81 2.5 1.16 70 

1963 2.4 1.24 64 1.8 1.18 48 

1962 1.9 1.22 47 1.8 1.16 44 

1961 1.9 1.22 42 2.0 1.17 46 

1960 2.1 1.24 46 1.6 1.19 36 

1959 1.6 1.23 33 1.2 1.18 26 

1958 1.8 1.21 37 1.7 1.17 34 

1957 2.2 1.25 41 1.7 1.20 33 

1956 1.7 1.24 32 1.5 1.20 29 

1955 1.5 1.23 28 1.7 1.20 31 

1954 2.0 1.24 34 3.3 1.20 57 

1953 1.7 1.24 29 2.7 1.18 44 

1952 4.3 1.23 67 2.4 1.15 38 

1951 4.2 1.20 62 2.6 1.15 39 

1950 3.2 1.18 47 3.2 1.16 47 

1949 3.1 1.33 46 4.4 1.30 66 

1948 1.4 1.27 20 3.5 1.22 50 

1947 4.0 1.22 54 6.2 1.13 85 

1946 6.6 1.18 85 7.8 1.05 100 

1945 11.3 1.17 127 8.8 1.00 99 

1944 12.4 1.16 120 9.2 1.02 89 

1943 11.2 1.10 94 8.6 1.00 73 

1942 11.5 1.34 78 8.7 1.26 59 

1941 5.9 1.29 36 4.5 1.26 28 

1940 4.3 1.25 24 4.0 1.25 22 

Mean 6.1 1.19 7,261 6.4 1.07 888 

Std. Dev 8.8 0.11 213 7.0 0.20 1,809 

FDIC BANKING REVIEW 45 2005, VOLUME 17, NO. 3 
A Formula for Calculating Deposit Insurance Assessments 

requirements that are less extreme and vary less 

from year to year than the requirements produced 

by the 1.25 DRR method. For 1991, for example, 

the two MA methods produce assessment rates of 

30.3 and 29.3 basis points respectively, compared 

with 62.8 points for the DRR method. In terms of 

volatility, the standard deviation of the assessment 

rate for the period 1940 – 1995 is reduced from 

11.1 basis points for the 1.25 DRR method to 8.8 

and 7.0 basis points, respectively, for the four- and 

six-year MA methods (see tables 3 and 4). In 

addition, the need for assessment rebates is nearly 

eliminated without a need to impose a zero-assessment constraint. Rebates are only required in 

1994 and 1995 under the four-year MA method, 

and in 1995 under the six-year MA method. 

In general, under the MA approach the BIF 

reserve ratio would tend to converge on a year-byyear basis around the BIF reserve ratio for the year 

initially chosen. For example, the BIF ratio in 

1940 when our experiment was started was 1.25 

percent. Over the years, both the four- and the 

six-year MA methods resulted in ratios that were 

close to 1.25 percent. The four-year MA, however, exhibited much closer convergence to the initial 1.25-percent value than the six-year MA. The 

mean BIF ratios for 1940-1995 were 1.19 percent 

for the four-year MA and 1.07 for the six-year 

MA. The variation around the mean for the fouryear MA method was also smaller. 

As emphasized above, an approach to assessments 

based on a MA would tend to have a countercyclical effect on bank income. From this perspective, if deposit insurance assessment rates were set 

using a MA method, the current risk-based assessment system would be improved, and the system 

would be easier for the FDIC to administer. Simply put, as compared with the current 1.25 DRR 

method, an assessment policy based on a moving 

average would make the assessment costs to BIF 

members more predictable from year to year and 

less of a burden during hard economic times. In 

the long run, of course, costs should end up the 

same under both approaches. 

The Constrained Moving Average 

Although the MA approach improves upon the 

current 1.25 DRR method in several respects, one 

major problem remains. Like the current 1.25 

DRR method, the MA method results in highly 

variable assessment rates over time, which can create funding uncertainty for banks. This problem 

can be lessened if the MA approach is modified 

with an above-zero (positive) minimum constraint 

on assessment rates. Under this variation, the 

FDIC would impose the MA assessment rate only 

when that rate was greater than the predetermined 

minimum rate. If it was not, then the FDIC would 

charge the predetermined minimum rate. 

We have incorporated a minimum constraint of 3 

basis points into the four- and six-year MA formulations. This 3-basis point constraint corresponds 

closely to the actual minimum effective rate 

observed in any year during the 1934–1995 period 

(see table 1). The results, shown in table 5, suggest that the new approach deals effectively with 

the problem of changing rates—the assessment 

rate remains constant over long stretches of time. 

In about half the years the assessment rate is the 3­

basis-point minimum. In addition, the technique 

of the constrained MA would further reduce the 

variability in the assessment rate. The assessment 

rate standard deviations in both the four-year and 

six-year constrained MA formulations are lower 

than those of the current 1.25 DRR (no rebate) 

policy (see tables 3 and 5). However, the constrained MA approaches would neither alleviate 

problematic high assessment rates, nor mitigate 

the resultant cyclical problem for the industry. In 

these regards, the advantages seem to lie decidedly 

with the two unconstrained MA approaches. 

2005, VOLUME 17, NO. 3 46 FDIC BANKING REVIEW 
 

 

A Formula for Calculating Deposit Insurance Assessments 

Table 5 Conclusions 

Constrained Moving-Average Methods— 

3 Basis Point Assessment Minimum 

4-year Moving Average 6-year Moving Average 

Assessment Assessment 

Year Rate (b.p.) BIF Ratio Rate (b.p.) BIF Ratio 

1995 3.0 1.85 3.0 1.53 

1994 3.0 1.76 7.9 1.46 

1993 3.0 1.49 15.6 1.15 

1992 19.4 1.01 24.5 0.55 

1991 30.0 0.67 28.9 0.19 

1990 39.5 1.09 31.5 0.65 

1989 28.0 1.21 23.9 0.89 

1988 17.9 1.09 16.1 0.82 

1987 16.8 1.26 14.9 1.02 

1986 12.5 1.17 11.9 0.97 

1985 10.1 1.22 8.8 1.02 

1984 7.6 1.21 6.0 1.03 

1983 7.3 1.24 5.4 1.08 

1982 4.4 1.24 3.0 1.10 

1981 3.0 1.30 3.0 1.18 

1980 3.0 1.25 3.0 1.14 

1979 3.0 1.29 3.0 1.17 

1978 3.0 1.24 3.0 1.12 

1977 3.9 1.24 4.0 1.12 

1976 4.5 1.24 4.3 1.12 

1975 4.5 1.26 3.7 1.14 

1974 4.3 1.24 3.5 1.13 

1973 4.6 1.27 3.6 1.16 

1972 4.8 1.28 4.0 1.18 

1971 3.5 1.31 3.8 1.21 

1970 3.0 1.30 3.0 1.19 

1969 3.7 1.33 3.3 1.22 

1968 4.2 1.28 3.4 1.18 

1967 5.5 1.34 3.9 1.24 

1966 4.4 1.35 3.0 1.27 

1965 3.4 1.38 3.0 1.32 

1964 3.0 1.41 3.0 1.35 

1963 3.0 1.43 3.0 1.36 

1962 3.0 1.39 3.0 1.33 

1961 3.0 1.39 3.0 1.32 

1960 3.0 1.40 3.0 1.33 

1959 3.0 1.38 3.0 1.31 

1958 3.0 1.33 3.0 1.26 

1957 3.0 1.36 3.0 1.28 

1956 3.0 1.34 3.0 1.26 

1955 3.0 1.31 3.0 1.24 

1954 3.0 1.30 3.3 1.22 

1953 3.0 1.29 3.0 1.20 

1952 4.2 1.25 3.0 1.17 

1951 4.1 1.23 3.0 1.16 

1950 3.2 1.21 3.2 1.16 

1949 3.1 1.36 4.4 1.30 

1948 3.0 1.30 3.5 1.22 

1947 4.0 1.22 6.2 1.13 

1946 6.6 1.18 7.8 1.05 

1945 11.3 1.17 8.8 1.00 

1944 12.4 1.16 9.2 1.02 

1943 11.2 1.10 8.6 1.00 

1942 11.5 1.34 8.7 1.26 

1941 5.9 1.29 4.5 1.26 

1940 4.3 1.25 4.0 1.25 

Mean 7.0 1.28 6.6 1.14 

Std. Dev 7.3 0.16 6.6 0.21 

The current system for setting deposit insurance 

rates may generate high premiums just when bank 

earnings are low, and thus raises questions about 

what level of assessments banks can absorb during 

a banking downturn. This level has not been 

established, nor has the question been put to the 

test since the current system was implemented. In 

the last banking crisis—that of the 1980s and early 

1990s—the law did not require the FDIC to 

adhere to a pay-as-you-go policy in response to the 

large insurance losses. Instead Congress approved 

modest increases in premium rates in 1989 and 

1991, the years of greatest stress to the insurance 

fund. Further changes introduced by FDICIA and 

DIFA established the current assessment policy, 

which requires that the BIF and the SAIF reserve 

ratios be maintained at the DRR and limits the 

ability of the FDIC to charge assessments if the 

reserve ratios are at or above the DRR. As a 

result, current assessment policy requires that 

deposit insurance assessments be set sufficiently 

high to cover costs during periods of high bank 

failures. 

We cannot see the future, but we can look at the 

past. This paper has examined the level and 

volatility of assessment rates that would have 

occurred if the current 1.25 DRR policy had been 

put into effect when the deposit insurance system 

first began operations in 1934. The analysis, using 

data on FDIC insurance losses, deposit growth, and 

interest rates from 1940 through 1995, indicates 

that a steady 1.25 percent reserve ratio for the BIF 

would have meant very heavy assessment levies in 

some years (years when the implied annual levy 

would have erased almost all bank profits), followed by zero levies as the industry’s condition 

improved. If significant banking industry losses 

should reappear, such high volatility in assessment 

requirements is not likely to be acceptable. 

This article has advanced an alternative movingaverage approach to the current assessment policy. 

This approach would not maintain the BIF at a 

predetermined ratio in every year, but would 

ensure that the BIF ratio would converge around 

FDIC BANKING REVIEW 47 2005, VOLUME 17, NO. 3 
A Formula for Calculating Deposit Insurance Assessments 

the predetermined ratio over the long run. It also 

avoids the two major weaknesses—high volatility 

and potentially prohibitive assessment burdens— 

inherent in the current 1.25 DRR assessment policy. Because this method relies on predetermined 

formulas instead of behavioral economic assumptions and estimates of future failures, premium setting would lie outside the realm of political influence or industry pressures. And because this 

method does not burden banks with oppressive 

premiums when they can least afford them (as the 

current policy does), the moving-average approach 

would have a beneficial counter-cyclical effect on 

the banking industry. 

2005, VOLUME 17, NO. 3 48 FDIC BANKING REVIEW 
 

 

 

 

 

 

 

 

A Formula for Calculating Deposit Insurance Assessments 

REFERENCES 

Blair, Christine E. 1997. History of the FDIC’s Deposit Insurance Assessment System. 

Unpublished manuscript. FDIC. 

Christopher, Benjamin B. 1978. The Calculation of Deposit Insurance Assessments: Some 

Issues of Procedure. FDIC Financial-Statistical Report 78-2 (unpublished). 

Congressional Budget Office (CBO). 1991. Budgetary Treatment of Deposit Insurance: A 

Framework for Reform. CBO. 

Federal Deposit Insurance Corporation (FDIC). Cited Years. Annual Report. FDIC. 

———. 1997. History of the Eighties—Lessons for the Future. Vol. 1. FDIC. 

Konstas, Panos. 1992. The Bank Insurance Fund: Trends, Initiatives, and the Road Ahead. 

FDIC Banking Review 5, no. 2:15–24. 

Office of Management and Budget (OMB). 1991. Budgeting for Federal Deposit Insurance. 

OMB. 

FDIC BANKING REVIEW 49 2005, VOLUME 17, NO. 3