Cheap Capital? Call It Deposit Insurance

The first deposit-insurance fund in America was established in 1829 by the State of New York. It ran out of money after the banking failures of 1837-1841.

Oklahoma established the first deposit-insurance fund in the 20th century, in 1908. In 1909 it ran out of money.

So have many deposit-insurance plans since then, including numerous state funds and the Federal Savings and Loan Insurance Corp. These days, the Federal Deposit Insurance Corp. is doing the struggling.

The Cost of Bearing Risk

Banks often lose vastly more than anyone thought possible, causing the deposit-insurance funds to run out of money. It then becomes obvious that the price charged was insufficient to bear the risk.

Is it possible, in advance, to set the right price for bearing banking risk?

The best estimate of the right price is the market price. And the only way to find the market price is to create a market for the item in question.

Thus, many commentators believe that deposit insurance should be provided by private-market insurers. Unfortunately, only the federal government -- with its remarkable power to borrow and tax -- is really credible as a deposit insurer.

Voluntary Alternative

How can the market price be found when the supplier of the insurance represents the monopolistic, coercive power of the state? Two steps can help find this price:

* Make deposit insurance totally voluntary, with depository institutions free to purchase it or not, as they judge best, and customers free to do business with insured or uninsured institutions as they see fit.

* Raise the price of deposit insurance high enough to cause a reasonable percentage of depository institutions, say 10% to 20%, to drop out of the program.

How might a depository institution analyze the pros and cons of continuing to buy deposit insurance at any given price? Some undoubtedly would be convinced that they must buy deposit insurance no matter what the price and that their survival depends on the government keeping the price low. But this is only a way of saying they have no economic reason to exist.

High Cost of Public Confidence

A rational institution would ask itself: How high would our capital have to be to inspire sufficient public confidence so that we could operate without deposit insurance?

Many knowledgeable colleagues have tried to come up with modern answers. Usually, after considering the leverage of financial companies without government insurance and the historical record of banking, they tend to arrive at a required capital ratio of 10% to 15%.

These days, large finance companies have an average equity ratio of about 11.5%. In 1890, with no deposit insurance and no Federal Reserve, American banks had an average capital ratio of 24%.

Ratios to Suit the Times

In 1925, after the Federal Reserve's founding but still before deposit insurance, American banks had a 12% capital ratio. Let's suppose that 12% is a reasonable estimate of the required equity-to-assets ratio. Let us also assume, for the moment, a situation with no income taxes.

Supposing, therefore, that it would take an equity-to-assets ratio of 12% to function without deposit insurance. An average bank, with 8% capital, would reason thus:

To do without deposit insurance, we would have to double our capital to 12% of assets. On this new capital, we would have to earn about 14% -- but the first 8% would come automatically from investing the new funds in risk-free assets.

Paying the Piper

Therefore, our cost savings from dropping deposit insurance must generate an additional 6% on the incremental capital. The incremental return required on the additional capital, expressed as a percent of assets, is thus 6% times 6% or 0.36% of assets. This is 0.48% of deposits, assuming the national average of deposits equal to about 75% of assets.

If we could save 0.48% of deposits by dropping deposit insurance, we could afford to raise the capital. In other words, we are willing to pay any deposit-insurance premium up to 0.48% of deposits, if that allows us to run with only 6% capital.

The analysis also makes it clear that deposit insurance is substitute capital. In effect, the federal government provides half or more of the required capital of the American banking system.

If 12% is the real capital required, the government has already provided depository institutions with an implicit capital of more than $200 billion through its deposit-insurance program.

Estimates Moving Skyward

Estimates of the explicit capital infusions needed to honor the government's commitments are rapidly escalating: $100 billion or more to thrifts and $20 to $40 billion to banks. The government is in the position of an investor who has committed but not paid in capital and is now subject to capital calls. Like a normal partner in an investment fund, the government never thought it would have to come up with the cash.

What is the appropriate price at which the government should provide substitute capital? The capital-assets pricing model suggests that the cost of capital is about 6% over the risk-free rate.

Since the deposit insurer retains its funds and invests them at the risk-free rate, it has to recover the other 6% from the depository institution. If this 6% is on capital equal to 6% of the institution's assets, the average price would be 0.36% of assets or 0.48% of deposits.

The announced increase in bank deposit-insurance premiums to 0.23% (already the premium paid by savings and loans) looks pretty modest by comparison.

Income-Tax Adjustments

Moreover, we have not yet adjusted for income taxes. The 0.48% market price is an after-tax number: With a marginal corporate income tax of 34%, the pretax market price for deposit insurance would be 0.73%.

This analysis makes it clear -- if it were not already clear enough from the financial difficulties of the deposit-insurance funds -- that deposit insurance is woefully underpriced relative to its market value. The government is providing massive amounts of cheap capital to the depository system, simultaneously creating large subsidies to depository institutions and large surprises to the public when the capital is called.

Nothing is more common than the observation that there is great excess resource commitment to the American depository institution system. Why? Because, filled with good intentions, the government in effect provided $200 billion or more in underpriced capital and created the means for the overexpansion of credit, risk, employment, fixed assets, and expenses.

In short, deposit insurance funds' running out of money and excess resources in the depository system are two sides of the same coin.

Mr. Alex J. Pollock is a partner in Pollock & Gold, a financial consulting firm in Clayton, Mo.

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