By moving to implement a risk-based system of deposit insurance premiums on Jan. 1, 1993, the Federal Deposit Insurance Corp. has move a full year ahead of the statutory deadline set by Congress.

But the system relies too heavily on subjective factors. It should place primarily emphasis on bank's capital as the best measure of risk to the deposit insurance funds.

We also argue for a greater differential between the rates paid by the best and worst banks. This would offer rewards and incentives for improving safety and soundness.

The healthiest banks should not only be paying the lowest rates under a risk-based system, but lower rates than they are currently assessed.

Protecting Both Good and Bad

As President Franklin Roosevelt warned in 1933, a deposit insurance system protects bad banks as well as good and puts a premium on unsound banking.

The flat rate has been used since the introduction of federal deposit insurance in 1933. All FDIC-insured depository institutions pay a uniform premium irrespective of their financial condition or the risk they pose to the insurance funds.

The record number of bank failures in recent years has rapidly depleted the funds and pushed deposit insurance rates upward.

The |Robin Hood' Approach

Consequently, the flat-rate structure has been increasingly criticized on the grounds that America's best banks -- which pose minimal risk of loss to the deposit insurance funds -- subsidize the insurance coverage of weak, poorly managed banks that pose a much higher risk to loss to the FDIC.

The flat-rate system employs a "Robin Hood" approach to premiums: Low-risk banks are unfairly taxed to pay for the insurance losses caused by past bank failures and weak, high-risk banks.

The Quest for Higher Yields

This excess deposit insurance tax places America's best banks at a distinct competitive disadvantage, since it saddles them with a cost that their unregulated financial services competitors do not have to bear.

Moreover, the flat rate encourages insured banks to pursue riskier investment or activities in search of higher yields, since no additional premiums are levied on such risks.

The lack of increased premiums to penalize risky behavior increases the risk of losses to the deposit insurance funds -- at the expense of the best banks.

|Risk Based' Blueprint

The Federal Deposit Insurance Corporation Improvement Act of 1991 only broadly defined a "risk-based assessment system" as one based on the probability that the fund will incur a loss, the likely amount of any such loss, and the revenue needs of the funds.

In determining the probability of loss, the FDIC must consider the risks attributable to categories and concentrations of assets and liabilities, and any other factors it deems relevant.

Congress apparently anticipated that the FDIC would exercise its discretion to devise a fair and readily implemented system that would relate premium levels to risk as accurately as feasible.

A strong argument could be made that Congress intended to use capital as the primary indicator of a bank's risk of loss to the deposit insurance funds.

Capital has been increasingly used by regulators as an indicator of a bank's financial health. They have had wide latitude in the establishment, application, and enforcement of capital standards.

However, in 1989 Congress curtailed the regulators' supervisory discretion, which it perceived to be ineffective in the regulation of savings institutions. The Financial Institutions Reform, Recovery, and Enforcement Act established a regulatory framework for evaluating savings institutions based primarily on capital standards.

Congress went a step further in the 1991 improvement act by expanding the capital-based approach to all insured depository institutions. Regulatory intervention is now tied directly to capital under a regulatory system of "prompt corrective action."

As a bank's capital declines, capital levels now trigger the requirement for prompt, increasingly harsher corrective actions. When equity falls below 2%, the appropriate regulator is required to close the bank before it reaches insolvency.

A bank's ability to solicit or accept brokered deposits, and make capital distributions, will be determined by reference to capital levels.

Proposed Risk-Related Rates

The FDIC has established a risk-related assessment rate for each of nine risk classifications. This rate is expressed in terms of basis points above or below the "average" assessment of 25.4 cents per $100 of domestic deposits, taking effect Jan. 1.

The FDIC has said it will hold both the Bank Insurance Fund and Savings Association Insurance Fund rates at the current 23 basis points for the best banks; the rest will pay between 26 and 31 cents, depending on condition.

The FDIC proposal relies heavily on the regulatory agencies' subjective judgment of a bank's total risk to its deposit insurance fund. As a result, the proposal is too subjective to provide realistic pricing for risk-based premiums.

Once a bank attains a sufficiently high level of capital, as a practical matter, it poses no risk of loss to the deposit insurance funds -- even if it is not considered one of the "best" banks from supervisory standpoint.

A risk-based system is not intended as a supervisory tool for identifying the best banks. The "high quality" categories should only mean that banks pose the lowest probability of loss to the insurance funds within a given assessment period.

If a bank's capital declines, it will pay a higher premium in subsequent assessment periods. Supervisory evaluations move away from a simplified concept of risk-based premiums and result in "overkill."

Risk-based premiums based primarily on capital level would provide an objective, straightforward, and more accurate measurement of the probability of a loss to the deposit insurance funds. Institutions that maintain higher capital levels would pay a lower premium.

Capital is a buffer against potential drops in earnings or adverse economic conditions. At the same time, capital relates directly to the owners' stake in ensuring long-term profitability and performance.

A capital cushion also shifts losses to the shareholders of troubled institutions, away from the FDIC funds.

Rewarding No-Risk Banks

At capital percentages closer to the average, other objective indicators of financial condition -- such as earnings and asset quality -- could be used to ascertain the reliability of reported capital. This objective approach avoids the undesirable effects of supervisory evaluations.

A more equitable system to reward the best banks might add a fourth group, "very well capitalized," to the FDIC classifications. These banks would pay an assessment rate that reflects virtually no risk to the deposit insurance funds. This performance incentive would reward a relatively small number of banks holding only a small percentage of the asset base of all insured banks.

This additional group might include banks with equity ratios of 8% and risk-weighted capital greater than 15%, and would account for 10% to 11% of the assessment base for all insured banks.

The FDIC has made a good start toward pricing in relation to risk. But it falls short of penalizing the riskiest banks with sufficiently higher premiums and rewarding the best with lower rates.

Mr. Faucette is a partner at Muldoon, Murphy & Faucette, a Washington firm that specializes in financial institutions law. He serves as Washington adviser and special counsel to America's Best Banks, an affinity group.

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