Deposit Insurance Myths Threaten Banking Industry
From its inception, federal deposit insurance has been laced with various myths. For almost 50 years, the realities of the banking business did not threaten these myths. In recent years, however, their fallacy has been exposed by technology-driven changes in the financial world.
The federal government's continued allegiance to these myths in the face of changing realities has inflicted great harm on well-managed banks and the economy - because when myth and reality clash, myth inevitably gets crushed.
If these myths are not quickly abandoned, a taxpayer bailout of the Bank Insurance Fund could occur.
Of the many myths, three are interrelated and particularly damaging:
* The BIF alone protects depositors.
* The American taxpayer will suddenly be at great risk if the balance in the BIF goes negative.
* In insurance programs, the strong have to pay for the weak.
Myth No. 1
Many people believe that the bigger the balance in the BIF, the better protected depositors are. In reality, the earning power of the banking industry, not the size of the BIF, protects the general taxpayer from losses incurred in protecting bank depositors. The BIF alone does not protect anyone from anything.
This reality reflects the fact that the BIF is merely a set of bookkeeping entries. The BIF does not exist as a real fund nor does it have any cash. Premiums paid by the banking industry have long since been spent by the government on other programs.
As of Dec. 31, 1990, the BIF balance, or uncommitted reserves, totaled $8.4 billion. This sum represents nothing more than a present value calculation of how the banking industry stands in its obligation to protect taxpayers from the cost of protecting depositors from bank insolvencies.
A positive fund balance of $1 would simply mean that the industry over time paid in one more dollar than regulators used to close insolvent banks. The BIF balance tells nothing about the industry's overall ability to meet its ongoing obligation to protect depositors against losses.
Understanding how the BIF really works goes a long way towards dispelling the myth that we need to fixate on maintaining a high BIF balance. Indeed, if anything, a high BIF balance actually is dangerous, because it can hide years of regulatory ineptitude in handling bank failures.
This year will be the eighth straight year in which BIF has experienced an underwriting loss. An underwriting loss occurs when an insurer's losses and related expenses exceed its premium income.
This long string of losses reflects an inexcusable regulatory performance masked by high fund balances. By 1980, the Federal Deposit Insurance Corp. (the BIF's predecessor) had accumulated $11 billion, or 1.16% of insured deposits. This high balance left room for considerable losses before concern over BIF's underwriting losses began to mount.
Bank insolvency losses exceeded BIF premium income for six years (1984-89) before these losses finally forced up BIF's premium rates. Regulatory ineptitude had dissipated billions of dollars previously collected from the banking industry.
By comparison, if the FDIC had entered the 1980s with only $1 billion of reserves, Congress would have had to address and correct regulatory shortcomings long before now. Healthy banks and the economy would have suffered much less as a result. In effect, the FDIC had too much money at its disposal in the 1980s, not too little.
Because a high fund balance fosters lax regulation, Congress should repeal the statutory requirement that the banking industry eventually rebuild the BIF balance to 1.25% of insured deposits. Instead, BIF should operate on a pay-as-you-go basis and maintain only a slight positive balance.
Taxpayer protection is the gut issue in deposit insurance because depositor protection is now a given, as demonstrated by the taxpayer bailout of the Federal Savings and Loan Insurance Corp. The banking industry, however, can protect taxpayers against deposit insurance losses only if it can pay all bank insolvency losses and still earn an adequate return on its capital.
To highlight the cost of regulatory failure in the 1980s, I have developed a chart, "Loss-Coverage Ratio for FDIC/BIF and FSLIC."
This ratio is calculated by adding the pretax operating earnings of insured institutions to the deposit insurance premiums they pay, then dividing that sum by the reported losses of the deposit insurer. The loss-coverage ratio is the single most important ratio in deposit insurance because it measures the ability of insured institutions collectively to pay for insolvency losses.
A ratio of 4, for example, means that industry earnings and premiums are four times the losses reported by the deposit insurer. The higher this ratio the better, because then insolvency losses are less of a burden on bank earnings and much less of a threat to taxpayers.
The chart demonstrates so clearly why a general taxpayer bailout of the BIF should not occur: BIF-insured institutions have been far stronger earners, relative to bank insolvency losses, than S&Ls were during the 1980s losses.
However, the downward slope of the BIF loss-coverage ratio should be of great concern. This trend must quickly be reversed to prevent the bankruptcy of the banking industry and a taxpayer bailout of the BIF.
Myth No. 2
Many believe that if the BIF balance goes negative for even one moment, the American taxpayer would suddenly be at great risk. This fear lies behind many arguments for increasing BIF premiums above the already draconian level of 23 basis points (1 basis point = 0.01%).
In reality, a temporary BIF deficit will not necessitate a taxpayer bailout for the BIF, if the banking industry can generate sufficient income to wipe out that deficit while still earning an adequate return on its capital.
Acknowledging this reality will prove important if a temporary deficit develops as BIF suffers large losses due to the cost of cleaning up the backlog of failed banks still operating today.
Better Off Without Illusions
Banks and the economy will be far better off amortizing any BIF deficit over several years at the present premium rate rather than sharply boosting the premium rate based on an illusory need to maintain a positive BIF balance.
Because the BIF balance is merely a present value calculation, a negative fund balance simply means that the banking industry has fallen behind temporarily in fully meeting the cost of protecting depositors in failed banks. Once regulators close all failed banks, the BIF should begin earning an underwriting profit that will quickly wipe out this deficit.
Restoring BIF to an underwriting profit, while holding to a 23-basis-point premium rate, is far more important than the size of the BIF deficit because, sooner or later, an underwriting profit will restore the BIF to a positive balance. A short-term BIF deficit, funded with Treasury debt, will not be a taxpayer bailout, as long as a healthy banking industry can repay this debt.
Deficits Should Be Short-Term
A second chart, "BIF Fund Balance," demonstrates one scenario under which the banking industry could repay a short-term BIF deficit within a few years while holding the BIF premium rate at 23 basis points.
This scenario incorporates loss estimates in line with some of the more pessimistic losses projected by FDIC Chairman L. William Seidman and by Charles Bowsher, the head of the General Accounting Office. Specifically, this scenario reflects $31 billion of bank insolvency losses for 1991-93.
Crucial to restoring the positive BIF balance plotted in the second chart is that BIF losses begin to decline sharply after 1993. By that year, regulators should have resolved the current backlog of troubled banks.
This forecast is eminently reasonable if the early intervention proposals for failing banks incorporated in this year's banking legislation have any impact.
Profits Can Resume by '94
By 1994, BIF should begin making an underwriting profit again, even after paying interest on the borrowings funding the temporary BIF deficit and BIF's working capital needs, assuming early intervention finally takes hold.
Once BIF starts generating a profit, it should roar out of its deficit. A return to a positive fund balance will mean that the banking industry will have fully funded all deposit insurance losses without any cost to the general taxpayer.
The forecast on which the second chart is based assumes $2 billion in bank insolvency losses in 1996. This loss estimate is down sharply from the present level of losses, but still more than 50 times the bank insolvency loss experience of the 1970s, expressed in 1991 dollars.
It is eminently reasonable to assume that BIF losses can be brought down to $2 billion by 1996, $5 billion less than BIF's expected premium income in 1996, at 23 basis points.
Interestingly, Canada has addressed the deficit in the Canada Deposit Insurance Corp. by tolerating a temporary CDIC deficit. Bank and thrift failures in the mid-1980s pushed the CDIC to a peak deficit of $1.09 billion at the end of 1986.
The CDIC then launched an eight-year program to eliminate this deficit while holding deposit insurance premiums at 10 basis points per dollar of insured deposits.
The CDIC deficit had dropped to $562 million by the end of last year. Eliminating this deficit by the end of 1994 is still feasible. What is working in Canada should work for the BIF.
Myth No. 3
Chairman Seidman, testifying before a House Banking sub-committee last December, articulated the myth that in insurance programs, "the strong have to pay for the weak." Others regularly cite this myth to justify raising BIF premiums on all banks, regardless of their individual risk to the BIF.
However, in actuarially sound insurance programs, each insured pays a premium in accordance with its perceived risk to the insurer. Thus, higher-risk insureds pay much more for their insurance than do lower-risk insureds.
Unfortunately, deposit insurance pricing lacks risk sensitivity. Consequently, as deposit insurance losses have climbed, the flat-rate BIF premium charged all banks has tripled since 1989. In effect, America's good banks are charged more and more because of the regulators' inability to prevent bank failures.
It is absolutely absurd that we should tax good banks more heavily to pay for ineffective regulation; yet, that is one consequence of the myth that the strong have to pay for the weak. Raising the premium rate charged to healthy banks increases the already high subsidy that flows from good banks to bad banks.
High Rates Hurt Stronger Banks
At 23 basis points, well-managed and properly capitalized banks now pay four or five times what they should pay for deposit insurance. This overcharging has become even more detrimental to banking because banks also are being forced to raise their capital levels.
If anything, the deposit insurance premium rate should decline as capital increases, because capital effectively acts as a deductible for deposit insurance.
The combined effect of higher capital levels and higher insurance premiums adversely affects banks in several ways:
* Banks find it harder and harder to compete against nonbank firms that now escape mispriced deposit insurance and the other regulatory burdens imposed on banks.
* Some banks may take new types of risks in an attempt to improve their earnings, risks for which the regulators are unprepared. This risk-taking may later cause losses for the BIF.
* Many banks may not be able to earn an adequate return on their capital without taking undue risks. Consequently, capital will flow out of these banks through higher dividend payments and stock buybacks.
Accentuating the Credit Crunch
Capital flight from banking will force a shrinkage in bank deposits that will further accentuate the credit crunch. The ratio of bank and thrift deposits to GNP already has plunged to a record low - one reason why the cry of credit crunch is now so loud. Capital flight will cause even louder cries.
The Congressional Budget Office has suggested recently that banks can afford to pay as much as 40 or 50 basis points for their deposit insurance. The CBO argument that a higher premium will only cause a few more banks to fail demonstrates a fundamental misunderstanding of how mispriced deposit insurance adversely affects banking.
Congress and the FDIC board, which also has the power to boost BIF premiums, should reject CBO's bad advice.
Banks will lose even more market share to nonbank competitors if they attempt to pass on rate increases above 23 basis points. This loss will accelerate the shrinkage of the deposit-taking industry and aggravate the credit crunch.
No one has made the case that America will benefit from forcing a further decline in the ratio of deposits to gross national product, the inevitable consequence of even higher deposit insurance premiums.
This year's banking legislation would authorize the FDIC to charge a risk-sensitive premium rate. However, because the FDIC is a government monopoly, it will never be able to price risk-sensitive premiums properly. Thus, the danger remains that premiums will rise even higher for sound banks.
BIF's Losses Must Be Trimmed
Quickly trimming BIF's losses is central to reducing premium burdens on banks and avoiding a taxpayer bailout of the BIF. Many, however, seem to believe that enormous BIF losses are inevitable and, therefore, all that Congress can do is figure out how to pay the bill.
Loss prevention generally is the No. 1 goal in public policy, whether it is minimizing plane crashes, deaths of newborn infants, environmental damage, or whatever. Only in deposit insurance does loss prevention seem not to have top priority.
The current banking legislation will attempt to force banking regulators to intervene earlier in troubled banks. However, projections of BIF's future needs do not reflect early intervention. It is almost as if there is no belief that early intervention will in any way work to lower BIF's future losses.
More Losses Must Be Avoided
For example, forecasts by the Office of Management and Budget project that bank insolvency losses in 1996 will still exceed the income collected from a 23-basis-point BIF premium rate. America cannot afford another five years of BIF underwriting losses.
One shortcoming of this year's banking legislation is that it does not offer any economic incentive to troubled banks to restructure themselves before they become insolvent.
Congress should enact the good-bank/bad-bank concept as a way of creating economic incentives to complement the already extensive powers the regulators now have.
Under the good-bank/bad-bank concept, a troubled but still solvent bank could spin off its problem assets into a industry financed loss-sharing pool in return for being recapitalized or acquired by a healthy bank.
The Bottom Line
In conclusion, the first chart forecasts the bottom line for the banking industry, the BIF loss-coverage ratio, based on the assumptions reflected in the second chart. After dipping as low as 2.7 in 1993, this ratio should begin rising again as bank earnings improve, and more importantly, as BIF losses begin to plunge.
By 1996, the loss-coverage ratio should climb back over 20, a ratio below which we should never allow it to drop again, if we want a healthy banking industry to continue serving us.
Putting BIF on a pay-as-you-go basis, as soon as any BIF deficit is wiped out, would help to ensure that regulators will quickly address deposit insurance underwriting losses, should they begin rising again.
Recipe for a Banking Bill
This is why this year's banking bill should:
* Not force the BIF premium rate above 23 basis points.
* Permit the BIF to borrow to fund a temporary deficit.
* Eliminate the requirement that the banking industry eventually restore the BIF balance to 1.25% of insured deposits.
* Authorize procedures to trim BIF's losses aggressively. Additionally, the FDIC board should not, on its own motion, raise the BIF premium rate above 23 basis points.
Without these measures, a banking industry weakened by continuing high deposit insurance losses and escalating deposit insurance premiums could threaten taxpayers with continued high BIF losses.
Mr. Ely is president of Ely & Co., a financial institutions consulting firm in Alexandria, Va.
PHOTO : Loss-Coverage Ratio for FDIC/BIF and FSLIC
PHOTO : BIF Fund Balance