229 4 REPLACING THE FDIC PRIVA TE INS URANCE FOR BANK DEPOSITS INTRODUCTION The collapse of Penn Square National Bank in Oklahoma City this past summer was one of- the nation's largest bank failures in recent years closed their doors or been forced to merge with healthier institu tions. Few d e positors in the failing banks lost any sleep worry ing about the safety of their accounts, however; they knew that despite the problems at the banks, their personal accounts were insured by the Federal Deposit Insurance Corporation (FDIC Since the start o f 1982, 34 other banks have To these depositors and to tens of millions of Americans the FDIC symbolizes the strength of the U.S. banking system.

Ironically, however, the FDIC may be contributing to the system's seeming new f ragility It is possible that the fail-safe guaran tees provided by FDIC have become a license for permissiveness to some bankers. Since the FDIC does not penalize speculative bankers for taking excessive risks, the FDIC eliminates a major incentive for ba nkers to handle depositors' money prudently. Had incentives existed that rewarded prudence, banks such as Penn Square might not have followed the road to financial ruin.

In the wake of the Penn Square collapse, the Federal Reserve System, the Comptroller o f the Currency,. and. the FDIC--'the govern ment agencies explicitly charged with the task of maintaining the integrity of the.banking industry--were accused of negligence in examining and monitoring the Oklahoma City bank.

The FDIC has been singled out for especially severe criticism.

Its dual roles as the primary guarantor of deposits and a princi- pal actor in bank regulation and liquidation would have led to considerable discussion of FDIC actions in any case, but the Corporation's decision to pay dep ositors of Penn Square rather than orchestrate a merger has led to considerable comment from all sides of the political spectrum.

Did the FDIC do the thing? Could it have prevented Penn Squarels demise? These questions have fueled more basic speculation about the role of FDIC and its future in a safer American banking system.

Students of the banking system agree almost universally that serious problems exist; most agree on the nature of these problems.

Debate rages, however, over the precise solutions. T he Depository Institutions Act of 1982, passed just before Congress recessed for the elections, included an amendment requiring the agencies insuring deposits at various institutions to consider solutions to the system's recognized problems and to offer s uggestions within six months. If these recommendations amount merely to fine tuning" the present system, they will be sadly inadequate.

The only cure for the ills of the present system is for federally provided deposit insurance to be phased out and replac ed with a private system of insurance THE FDIC's BACKGROUND AND PRESENT-DAY STRUCTURE The creation of the FDIC and enactment of other banking reforms during the Depression stemmed from the popular misconcep tion that bad banking practices, compounded by e xcessive competi tion and speculation, had caused the bank failures of the 1930s.

Congress responded by limiting bank competition, increasing federal supervision of financial activities, limiting banks asset acquisition powers, restricting their rates to d epositors and establishing capital standards. But the reform viewed by Congress as central to an immediate restoration of confidence in the financial system was.the creation of a federal system of deposit insurance.

Support for the new system was by no means universal.

President Franklin Roosevelt and the bankins community opposed its introduction. As the New York Times heaalined on March 26 1933 BANKERS WILL FIGHT DEPOSIT GUARANTEE PENDING MEASURE] WOULD CAUSE NOT AVERT PANICS, THEY ARGUE BAD BANKING WOU LD BE ENCOURAGED AND HONESTY DISCREDITED, SAY FOES The lead paragraph stated Tlhere is one proposal that bankers here still vigorously oppose--any plan for guaranteeing bank deposits. Attempts to guarantee bank deposits, the bankers say, have always ended disastrously. The plan puts a premium on bad banking and drives sound bankers out of business The chief arguments of the bankers against a bank deposit guarantee law the Times article concluded, 'lare that it encourages bad banking, 3 discredits honesty, ability, and conservatism, and would cause and not avert panics. They say that a loss suffered by one bank jeopardizes all banks.

The legislation nonetheless passed. Creation of the FDIC was part of the Banking Act of 1933.

Federal Reserve Act, the FDIC was empowered Offered as an amendment to the to purchase, hold and liquidate, as hereinafter provided the assets of banks which have been closed; and to insure the deposits of all banks.

Insurance coverage originally was limited to 2,500 per depositor per bank. This was raised to $5,000 in mid-1934, and has since increased to $100,000.

Bank failures dropped off sharply after the creation of the Corporation-from 4,004 in 1933 to 61 in 1934 (see Table I Unquestionably, 'the provisio n of federal deposit insurance enhanced confidence in the system and reduced the threat of banking runs which had been a major cause of earlier failures other more significant forces that also contributed to the-sub stantial decline in bank failures But t here were First, more than 9,000 banks had failed in the four turbulent years preceding the introduction of federal insurance. Most weak banks (and some that were not so weak) thus had been eliminated.

Those institutions that had survived until 1934 comman ded confidence Table I I Year Number Bank Failures Business Failure Rate* M billions 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 499 659 1,352 2,294 1,456 4,004 61 32 72 83 109 104 122 133 154 100 61 62 48 46 qhe business failure rate is defined as t he number of failures per 10,000 business enterprises M hanh of the public is equal to demand deposits in commercial banks plus cash in the 26.10 26.64 25.76 24.14 21.11 19.91 21.86 25.88 29.55 30.91 Source: Historical Statistics of the U.S Colonial Times to 1970 Bureau of the Census, September 1975, pp. 1038-1039, 912, 992. 4 from the public by the very fact of their survival.

Secondly, not only the bank failure rate, but also the general business failure rate, slowed dramatically during the period from 1 932 to 1934 (see Table I While the business failure rate peaked in 1932 and bank failures did not peak until 1933 the lag indicated by these statistics is not unusual. Because the primary products of banks are business loans, the health of the banking ind ustry usually lags slightly behind the upturn of the business cycle. Therefore, bank failures would have slowed in 1934 without the institution of deposit insurance.

Finally, growth in the money supply (see Table I) also tended to reduce bank failures in 19

34. M1, the most appropriate measure of the money supply for that period, fell to its low of 19.9 billion in 19

33. The 25 percent decrease in M1 from 1929 to 1933 is generally cited as a primary cause of the bank failures.

Thus pumping money back int o the economy in 1934, increasing bank reserves provided the liquidity necessary to stabilize the banks.l it is not suprising that when the Federal Reserve began I In short, while creation of the FDIC can be credited with having had a positive impact on c o nfidence in the banking system it alone did not save the system. Other, not entirely unrelated forces combined during the period around 1934 to slow the rate of bank failures. while the drop in bank failures might have been slower without the FDIC, eviden c e indicates that failures still would have declined substantially after 1933 facts, federal deposit insurance was viewed by many as the salva tion of the banking system. Coverage expanded rapidly. By 1980 98.2 percent of the commercial banks in the United States were insured by the FDIC; 79.9 percent of total deposits were covered In spite of these The FDIC uses three basic means to insure deposits 1 A failed institution can be merged into a healthy bank which agrees to accept full responsibility for all d e posits including the uninsured portion of the larger deposits. Frequently the FDIC must subsidize the merger. Example In July 1974, when the Comptroller of the Currency declared Long Island's Franklin National Bank insolvent, the FDIC assumed $2.083 billi o n of Franklin's assets to facilitate a merger with the European American Bank For a discussion of the role of the Federal Reserve System during the Depression, see Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867-1960 (Prin ceton, N.J Princeton University Press, 1963).

Frank J. Fabozzi, ed., Case History of Bank Failures (Hempstead, New York Hofstra University, 1981) p. 341. 5 2) Failures are not always called failures. A large bank may be supported with loans or other aid ra ther than being merged or liquidated. Example In April 1980, the FDIC kept First Pennsylvania afloat by lending it $325 million in the form of five year, low interest subordinated notes.3 for the insured portion of their deposits then liquidated. Example I n July 1982, the FDIC reluctantly concluded that Penn Square National Bank had too many contingent liabilities to be considered as a possible merger partner by other banks. The decision was made to close the bank and pay depositors-even though nearly half of the deposits at Penn Square were uninsured 083 percent of total deposit balances-=a flat rate based solely on the total deposits in the bank pays its expenses and maintains its insurance reserve fund.

After covering expenses, losses, and additions to i ts reserve fund, the FDIC returns 60 percent of its remaining premium income to the insured banks. These refunds have historically lowered the cost of deposit insurance to between .03 and 04 percent of a bank's total deposits though today's effective rate may be slightly higher defense in the event of bank failures, amounts to $12.3 billion or less than 2 percent of total insured deposits. The FDIC also has a $3 billion line of credit with the U.S. Treasury Department. Analysts feel that the Federal Reserv e System and the Treasury would provide funds beyond this, however, should serious failures threaten 3) If all else fails, the FDIC will pay depositors in full The institution is As an insurance premium, the FDIC charges its member banks From this income, t he FDIC The reserve fund, which serves as the FDIC's first line of Premiums and Risk Takinq By charging a flat percentage premium, the FDIC violates a fundamental rule of insurance. Insurance premiums in general are based on the perceived risk of the acti vity being underwritten.

There is, however, little correlation between the total deposits of a bank and its potential risk of failure factors are the quality and integrity of the management, the relative security of me bank's loan portfolio, and the amount of capital available to back up the portfolio. The FDIC's flat-rate insurance premium'creates the wrong kind of incentives for banks, for it may actually encourage excessive risk taking by depository institutions More relevant Ibid 9 P. 48 Mark Flannery D eposit Insurance Creates A Need for Bank Regulations Federal Reserve Bank of Philadelphia, Business Review, January/February 1982, p. 18. 6 Imagine a banking system without deposit insurance. Banks decide to take on more risk because riskier loans general ly command a higher interest rate such loans, but the interest on those paid back should more than offset the bad loans lost. With careful management, carrying some I'riskyI1 loans in a portfolio can prove to be profitable.

Problems mount when a bank takes on too much risk by concen trating a significant portion of its loan portfolio in one region5 or one industry In these cases, the bank may be threatened because of reduced demand in a single sector of the economy.

Risk of that sort-where the health of th e institution is too dependent on a narrow set of factors-is most dangerous to the bank The default rate is higher on As a bank takes on more portfolio risk, chances increase that more loans will turn bad and, subsequently, that the bank will start losing assets and be unable to pay its depositors the absence of deposit insurance, depositors detecting this dangerous trend in their bank will demand higher interest rates to cover their own increased risk16 or will move their funds to a safer bank discipline, limiting the risk a bank carries as it forces the institution to internalize the cost of taking on a riskier loan portfolio.

Most depositors, of course, are unable to monitor their banks well enough to determine the degree of risk to which their deposits are exposed. Deposit insurance thus becomes desirable.

Naturally, deposit insurance increases the bank's costs because of the charge for premiums interest on deposits. But depositors accept the lower rate in return for the peace of mind provided by knowing their deposits are safe In This threat from depositors provides an effective This means that banks must pay lower The burde n of monitoring the bank thus is shifted to the As a bank begins to take on a more questionable insurance company loan portfolio, thus increasing its chances of failure, insurers theoretically, should protect themselves--by raising premiums for example. Th i s forces the bank to internalize, in other words to bear, themselves, the cost of taking on more risks-as does the threat of action by uninsured depositors in the theoretical case described earlier with no deposit insurance. While riskier portfolios may c arry higher interest rates, part of that potential increase in profits will be offset by higher insurance premiums This situation cannot always be avoided because of current banking laws.

One of the strongest arguments for interstate banking is the increased safety that would result as banks established more diversified portfolios.

This assumes a world with no ceiling on the amount of interest that may be paid to depositors 7 In a freely operating bank system, therefore, insurance premiums would vary accor ding to risk. The FDIC, however, does not do this. Its flat-rate fee is set by law. Bankers can increase the risk of their portfolios--and hence their potential yield-without any corresponding increase in insurance costs.

The type of incentive thereby provided is reflected in banking policy today as banks shift their emphasis from safety to the maximum employment of funds.

Washington Post shortly after the Penn Square fiasco The object of many big banks is to make as many big loans as possible, not to res trict lending to the most reliable possible custamers.lf Felix Rohatyn, a senior partner in the major New York investment banking firm of Lazard Freres and Company, adds that an emphasis on performance has replaced more conservative attitudes in banking o v er the past 20 years. Quality restraints, Rohatyn claims, have been replaced by the desire for growth Is it any wonder that Penn Square concentrated heavily on risky loans costs, the bank chose to make loans to risky new oil drilling companies As Hobart R o wen noted in the Seeking quick growth and faced with no offsetting Banking law prevents the FDIC from dealing with situations like Penn Square by Ifpunishingi1 risky behavior through increases in insurance rates. At the same time, adequate federal monitor ing of the more than 14,000 insured banks in the U.S. has become impossible. Consequently, the FDIC and other banking agencies have turned to regulation instead.

Excessive Regulation Rules and regulations touch almost every aspect of banking operations. Fo r example, banks are required to maintain specific capital/asset ratios. In a system without the FDIC, prudent banks with a higher than average risk exposure would maintain higher capital/asset ratios safely maintain lower ratios. The federal regulators, h owever apply uniform standards. Conservative banks thus are required to hold too much capital, while some over-adventurous bankers may be holding too little. The measures used to determine the capital asset ratio are also standardized. As a result, they a r e inappro priate for some. banks More conservative banks could Reserve requirements imposed on banks are another restrictive and costly government regulation. These requirements supposedly serve a two-fold purpose. They control the money supply and ensure that banks have enough reserves on hand to meet depositor requests for cash. Different banks, however, need different Hobart Rowen Could Our Bank System Crumble?" Washington Post, August 22, 1982, pp. C1-C2. reserve levels to meet depositors' requests for money. The share of volatile accounts varies enormously among banks and through time, and most banks can predict with fair accuracy their cash needs. Yet government agencies require uniform reserve levels of all banks of a similar size. These standardized reserve require ment ratios clearly leave many institutions holding more money than is necessary for safety.8 sion of conservative banks. This reduces not only these banks potential for growth, but also the available pool of loanable funds, thus affecting the growth potential of the economy as a whole. Paperwork requirements, designed to assure. federal author ities of compliance, add to the costs of regulation Excessive capital and reserve requirements brake the expan A recent study by the United Bank of Denver attempted to measure the total cost of compliance with government regulations.

Researchers concluded that regulation costs approach 91 percent of the bank's after-tax income of 13.1 million, or more than $11 million each year.g This is a conservativ e estimate. It includes only the explicit, out-of-pocket costs of complying with examina tions and reports and maintaining reserve requirements NO attempt was made to calculate the enormous costs of forgone investment opportunities caused by banks having to comply with the myriad of restrictions imposed by government regulators.

Mergers Another problem with FDIC insurance concerns the merger policy pursued by the agency and encouraged by other federal banking authorities. Because deposit insurance applies only to the first 100,000 in an account, large depositors still need to monitor the institution holding their money. Should a bank begin to take on too much risk, these depositors (often other financial institutions) should identify this dangerous trend a nd should effect a change by threatening to move their funds to a safer bank In most cases, however, large depositors fail to do this.

Consider the Penn Square fiasco. Credit unions, 'savings and loan associations, and a number of banks (including two of t he nation's top ten) were caught with uninsured funds in a failed bank and could lose a considerable amount of money. Clearly, no one expected the FDIC to allow Penn Square to fail. Federal banking authorities have a history of avoiding outright bank This paper is concerned only with reserve requirements as a safety measure and does not consider their role in controlling the money supply.

Harold R. Smethhills, Jr The Cost of Government Regulation: How Much is Enough?" Bank Compliance, Winter 1981, p. 14. 9 failure at almost any cost.1 When a bank cannot be saved, the a healthy bank. The FDIC subsidizes these mergers and, in return the acquiring institution agrees to take responsibility for the liabilities of the acquired bank. As a result, depositors with b alances above 100,000 receive implicit deposit insurance above the legally insurable limit FDIC typically does everything possible to arrange a merger with Confident that the FDIC would follow the usual merger policy banks and other financial institutions were quite willing to place funds with Penn Square and enjoy rates of interest that otherwise would have made sophisticated investors suspicious.

Hence, the actions of Chase Manhattan, Continental Illinois, and the other banks, savings and loans, and cred it unions with money in Penn Square were completely rational, given the past performance of the FDIC--just as the actions of Penn Square itself were arguably rational, given the current flat-rate insurance premiums.

The FDIC nows seems to realize this. Ch airman William Isaac recently admitted Dleposit assumption transactions involving failing banks have the major disadvantage, under current law of making all general creditors whole and thereby eroding marketplace discipline. We are considering the desirab i lity of a statutory change to permit deposit assumptions without providing a complete bailout for larger creditors CORRECTING THE FDIC's SHORTCOMINGS a) Variable FDIC Premiums One remedy for the FDIC's shortcomings would be to allow the agency to vary its premiums depending on a bank's riskiness.

Bank examiners, as a matter of course, already assign banks to one of five categories according to the soundness of their opera tions.1.2 Under the current system, however, this categorization of banks has little real impact. Banks assigned to higher risk categories are sometimes examined more often, but that is about the extent of the effect of these categories lo This "failure phobia" of federal banking authorities also helps explain the willingness of banks to take on foreign debt that in the event defa ulted foreign loans seriously endangered a U.S bank, the banking authorities would provide some sort of "bail-out" to prevent the bank's demise.

William M. Issac, Chairman Federal Deposit Insurance Corporation, in a speech before the American Bankers Association's convention, October 19, 1982, p. 6.

Banks receiving a ranking of "one" are considered the strongest while those placed in category "five" are considered to be in imminent danger of failure Most observers expect l1 l2 10 Insurance premiums could vary according to risk category.

This would give banks an incentive to follow a more prudent lending policy were assigned to a higher risk category, their premium costs would increase, thus discouraging excessive risk taking As banks took on a more risky l oan portfolio and The trouble with this proposal is the monopoly position of the federal banking authorities. Riskiness of a loan portfolio cannot be measured easily strongly-perhaps correctly-with the risk assessment. Where could the banker register his p rotest ment's only source of appeal would be the agency that hired and trained the examiner Suppose a bank's management disagrees In fact, the bank manage If there is any doubt that risk assessments by federal authorities might be.something less than comp l etely accurate consider again the Penn Square case. At the time of its,failure in July 1982, Penn Square National Bank was officially listed in category "three I1 Category Ilthreell banks are recognized as having problems, but failure is considered Ifonly a remote possi bility II b) Choice of Federal Insurer As a partial solution to this monopoly problem, it has been suggested that banks be able to choose between insuring with the FDIC or with the Federal Savings and Loan Insurance Corporation FSLIC). Comp etition between the two agencies would then solve the monopoly problems of FDIC risk-based insurance.

For effective competition between the two agencies to develop however, both would need the authority to examine all depository institutions-making indepen dent judgments as to the risk exposure of a particular bank or savings and loan. Effective competition for the insurance premiums would further require that the insurer control the examination and regulation of the particular bank.

This is not the case today. Various agencies are responsible for examination, regulation, and insurance. These powers would have to be concentrated in the FDIC and FSLIC.

Even if the necessary redistribution of power were politically feasible, the government agencies probably would soon argue that coordination of their policies was necessary to reduce overlap.

This would eliminate competition.

Furthermore, as government agencies, the FDIC and FSLIC make no profit and therefore would have few incentives to increase the efficien cy of their operations. Neither would they have much reason to reduce the multitude of rules and regulations applied to depository institutions or to minimize the cost of deposit insurance.

Establishing federally supplied variable-rate insurance even with llcompetitionll between the two insuring agencies, would fail to resolve the shortcomings of the present system. Excessive risk taking might be discouraged, but the over-regulation problem would not be addressed. 11 Endinq Merger Activities Another refor m proposed is for the FDIC and FSLIC to stop arranging mergers depositors only to a specified ceiling, incentives would be created for larger depositors to keep close track of the activi ties of their banks.

Mark Flannery, a professor of finance at the Uni versity of Pennsylvania, recommends that the extent of federally provided deposit insurance be reduced to cover only the first 10,000 to 20,000 of each account.13 Small savers would be protected while larger depositors, most of whom have the expertise nec essary to monitor their bankers and the power to affect their behavior would be given the incentive to do so. This makes sense, however only if federal banking authorities stop arranging mergers.

Flannery's suggestion also fails to address the problem of o ver regulation and inflexibility, and it offers no incentives for regulators to change their present behavior By allowing banks to fail and reimbursing The above proposals attempt merely to fine tune the current system of deposit insurance as a service of government. What would happen if the government no longer provided such insurance THE PROMISE OF PRIVATIZATION An ideal deposit insurance sistem must provide safety and flexibility.

The extensive bank failures of the 1930s led Congress and the federal ban king authorities to determine that the savings of large numbers of people must never again be jeopardized. The authorities failed to distinguish, however, between'ensuring the safety of deposits and ensuring the safety of banks. Over the past 50 years, fe d eral banking authorities have chosen to pursue the latter goal as a means of achieving the former. This has contributed to the morass of rules and regulations surrounding the banking industry. The cost of this approach is becoming more apparent as deposit ory institutions find themselves unable to meet rapidly changing technological and economic conditions.

A flexible system is needed for banks to be able to accommodate this rapid market evolution It is impossible for today's Congress men and regulators to imagine conditions under which banks will operate in 2030, just as it was impossible for those of the 1 930s to picture conditions today. It is the bank depositor who ultimately bears the burden of this inflexibility. Individuals and businesses purchasing financial services have a wide variety of needs.

Placing tight controls on depository institutions in an effort to protect them from failure also prevents their developing methods l3 Flannery, 3. cit.

I of better serving customers 12 The challenge is to devise a system that will meet the safety demands of depositors--especially the small, unsophis ticated d epositors-while allowing for maximum efficiency and flexibility. The evidence indicates that this can be done only through the private market.

Congress should eliminate the FDIC and allow banks to choose private insurance to meet their needs. If the feder al government is to retain any insurance function"at all it should be confined to that of ''insurer of last resort that is it should provide Icatastrophel' coverage, stepping in with assistance only when insurance losses reach a specified, unacceptable le vel.

Private insurers would undoubtedly charge variable insurance premiums depending on the risk exposure of each bank. Matching a bank's insurance premium to the risk of its portfolio would force it to internalize the cost of its decisions, thus discourag ing unreasonable portfolio risk still be a monopoly problem a bank that was unhappy with the premium being charged by its insurer could shop around for a better deal incentives for improved performance. Insurance companies would have to strike a balance b e tween offering a bank an attractive deal and ensuring that its premium was sufficient to cover the risk of failure properly. Moreover, competition would lead to more efficient examinations, appraisals, and regulation, thus lowering the cost of insurance t o depositors and bank stockholders problem. If large depositors could no longer count on federal banking authorities to bail out a troubled bank, they would create additional incentives for safer banking operations by threatening to move large deposits els e where or insisting that the bank obtain additional insurance to cover their funds in the event of failure Even if the FDIC were to charge variable rates, there- would Under a private competitive system Competition provides A private insurance system also w ould eliminate the merger Banks also would be supervised more efficiently. If private insurers were made responsible for paying depositors in the event of failure, they would have strong incentives to monitor banks closely--especially as problems began to develop. These insurers would, quite properly, concern themselves with the capital/asset ratios, the reserves, and the type of loans held by the bank. If private insurers could monitor such details, setting standards for banks as part of a total insurance package, why should federal banking authorities continue to exercise this power? After all who would have the greater incentive to promote the safe opera tion of depository institutions-private companies with their money on the line or government regulato rs regulations imposed on banks could be eliminated.

Thus, most of the 13 Companies providing deposit 'insurance through the private markets also could be expected to take an active interest in other areas of a bank's operations. For example, a bank's deci sion to offer a new service to its customers would certainly be of interest to its insurer. Similarly, a bank's ability to open a new branch without weakening its position would clearly be investi gated by the company (or companies) providing its insuranc e. As with other aspects of a bank's operation, private insurers would have a much'stronger incentive than government employees to carry out this oversight efficiently. Government regulation of these matters, therefore, would be unnecessary.

The enhanced f lexibility resulting from a private insurance system would be just as important as the improvement in efficiency It is in this respect that privately provided deposit insurance has great advantage. The logistics o.f examining thousands of banks requires t hat arbitrary, but uniform, standards and guide lines be established to ensure that each is dealt with fairly.

Yet, banks are not identical. Differences in management, location target markets, and competitive situations make uniform standards inappropriate for many banks. Private insurance companies, each overseeing a smaller number of institutions, could tailor insurance programs to meet the needs of individual banks. This would allow each bank to adopt to its own market and customer needs. A higher capit al/asset ratio could be used to offset lower reserves and vice versa. Similarly, new services could be offered to depositors if the bank reduced the risk exposure of its loan portfolio.

The advantages of such flexibility would be enormous.

Individual banks would benefit because they could adjust to changing conditions within their communities. Customers would be better served, since banks would be better able to meet their needs, be more profitable, and thus, pay depositors higher rates.

Flexibility would be assured by the competitive nature of a privately provided insurance system To keep existing clients or attract new ones, an insurance company would have to offer banks a more attractive package than did its competitors.

A system of privately provided deposit insurance offers key advantages. It would enhance the safety of deposits within the system and increase the ability of the banking system to adjust to changing conditions and needs of consumers. It would reduce the burden of over-regulation, there by increasing the available loan pool and contributing to the long-run health of the economy.

PRIVATIZATION--A BLUEPRINT Though private insurance would represent a significant change in the direction of current U.S. banking policy, it is not an untried dir ection not only just 50 years old, it is also unique to the United Federally provided deposit insurance is 14 States No other major banking system has government provided deposit insurance.14 super-cautious Swiss--offer no deposit insurance at all. Yet th e se banking systems do not suffer from a lack of customer confidence. Even in this country, there are billions of dollars of uninsured deposits. The owners of the more than $200 billion in money market funds do not seem to be losing sleep over the lack of f ederal deposit insurance. Furthermore, credit unions in several states are now being allowed to opt out of government insurance systems and obtain private coverage. Private companies set higher standards for providing insurance than do their govern ment c o unterparts, forcing many credit unions to reduce their risk exposure before they will be accepted. Credit unions are evidently willing to make such adjustments, however, as demonstrated by the growing number of such institutions choosing to protect their depositors through private insurance.

Among them differ from pre-FDIC days in which thousands of banks failed?

There are important differences between the financial world of the 1930s .and 1980s, and therefore it is unlikely that history would repeat itself Banks in most countries--including the The privatization proposal still raises many questions.

How would a contemporary private i nsurance system In the first place, almost all banks that failed in the Depression were unit banks-=banks with no branches. From 1921 to 1931, only seven suspensions occured in banks with more than ten branches. California, the principal statewide branchi n g state experienced few failures. Canada, with countrywide branching had only one failure--and that was in 1923.15 banks, unit banks cannot meet deposit claims and losses in one area with funds and offsetting profits in another. In other words, they are m o re vulnerable to the effects of bank runs and local adverse economic fluctuations So the trend to statewide branching and interstate banking in the coming decade should further reduce the chances of massive bank runs and bankruptcies Unlike branching Seco n d, a contemporary private insurance company would be more diversified and thus safer than its equivalent during the Depression. Deposit insurance in the early 1900s consisted largely of state legislated companies subject to the same structural inadequacie s as the FDIC today and subject to the same restrictions on diversity suffered by the unit banks banks failed, the entire state insurance system would be jeopardized. When a couple of local l4 Nor does any other country have a banking system as fractured a s ours.

The existence of nationwide branching in other countries helps to stabilize their banking systems poor economic conditions, losses at those branches may be absorbed through the profitable operation of branches in other parts of the country.

George J. Benston How Can We Learn from Past Bank Failures?"

Magazine, Winter 1975, p. 21 If one region happens to suffer from especially l5 Bankers I 15 Third, the insurance system today is capable of instilling the consumer confidence necessary to make its guarantees effective.

Insurers have become masters at diversifying risk and assessing premiums in complex cases. Consider the range of business under taken by companies such as Lloyds of London and Prudential.

Further, eighteen private companies currently insure credit unions throughout the country with considerable success. Accord ing to Sam Rizzo, President of the National Deposit Guaranty Corporation of Columbus, Ohio, this has provided valuable experi ence toward the design of a bank deposit insurance system.

How would the transition be handled? It is important that the transition to private deposit insurance be gradual and cautious.

This would allow time for the market to adjust, resulting in a smooth and orderly transition. A transition period of, say, seven years would also allow time for the development of the insurance market and the education of consumers.

One possible scenario would be to gradually reduce the size of an insurable deposit over a period of three to seven years.

During the first year of the phase-in period, the FDIC's role as merger-maker would be eliminated. The insured portion of each deposit would also be lowered from $100,000 to, say 85,0

00. In succeeding years the insured portion of deposits would continue to be reduced in a stepwise fashion. The larger, more sophisticated depositors would thus move out of the system first with the market power to affect bank behavior, would press the management of questionable banks to strengthen their financial positions or obtain suppleme n tary insurance. By the end of the phase-in period, when the smallest depositors finally gave up their federal deposit insurance, the banks and the private insur ance companies would have gained the experience necessary to assure the safety of smaller depo sitors; the new system would have been allowed time to adjust and prove its viability regional deposit insurance is that an insurance company should avoid concentrating its accounts in one part of the country.

Today's insurers pursu e geographic diversity, as well as reinsur ance, as a matter of course, particularly for potentially large claims. Certainly the industry would be no less prudent when insuring the banking system. The chances of a bank failure's causing an insurance compa n y failure thus are slim. Insurance companies would probably insist that very large banks obtain insurance from several sources These depositors One lesson of the pre-1930s experience with private or Consumer confidence is critical for the success of any i n surance undertaking. To assure consumers of the system's sound ness it might prove necessary for the government to approve deposit insurers. Such oversight should be kept to a minimum however, and might not be needed. The great advantage of private insura n ce would be flexibility individual contracts that reflect the conditions of individual institutions. Government oversight of insurance companies might Bankers and insurers could negotiate 16 place unwarranted restrictions on these contracts, thereby recre at ing many of the problems it was designed to solve.

How would a system of private insurance deal with entry?

The general arguments for reducing regulation also apply to the regulation of entry into the industry. More liberal entry condi tions would increase competition and result in better service for bank customers.

The Heritage Foundation study The Case for Banking Deregula tion argued that bank chartering agents should do no more than assure themselves of the existence of adequate capital and the goo d character of the founders before granting a bank charter.16 A simple requirement that a new bank must obtain deposit insurance before it could operate would have a similar result insurers would not risk their funds if the prospective founders were, say, convicted felons, or if an insurance inspector felt that the new bank did not have a reasonable chance of survival Private Questions have been raised concerning the willingness of private insurers to guarantee the deposits of new institutions A competitiv e insurance system, however, would treat these accounts much as banks treat loans to new enterprises. Because of their increased risk, new ventures, would pay higher premiums. Indivi dual insurance companies might also guarantee only a part of their deposi ts in order to spread their risk among several companies. But a new bank with reasonable prospects should have little trouble in finding adequate insurance for its deposits.

Not all U.S. banks carry FDIC insurance. Since the goal of private insurance is to provide more, not less, flexibility than the present system, insurance should not be required by the government Should all banks be required to obtain private deposit insurance?

Most banks probably would need deposit insurance to satisfy and therefore re tain, depositors. At those few banks whose depositors did not demand insurance, the message would be that the depositors felt secure with their funds uninsured, or that the bank's rate of return was high enough to compensate for the risk the depositor tak es. Why should these consumers be forced to accept something they clearly feel is unnecessary?

Requiring a certain level of deposit insurance, moreover As new instruments were developed to meet changing would necessitate the drawing of arbitrary lines acco unt be a !!deposit for the purposes of requiring deposit insurance demands, new decisions would have to be made As long as customers When would an l6 See, Catherine England The Case for Banking Deregulation Heritage Foundation Backgrounder No. 174, March 26, 1982.

I 17 were told whether their financial assets were insured or not they should have the right to place funds in an uninsured account in return for a higher rate of interest.

Would a private insurance system dry up venture capital for new enterpri ses? Some critics of private insurance fear that true risk related premiums would reduce the supply of capital to new or risky enterprises. Under the present system, some banks Penn Square, for example) are able to specialize in risky port folios because t he bank and the borrower are subsidized by the FDIC's flat-rate premium structure. If an insuring agency were to vary the premium rate with portfolio risk, however, it would inhibit the concentration of risky loans in single.banks. The critics maintain th at'a system of private insurance, therefore would reduce the supply of loans to new ventures, which, though risky, are responsible for much innovation and economic progress.

This need not be the case.

Most banks would continue to seek some high return/hig h risk loans to boost their portfolio yield. In moderation, these more risky loans would not influence the individual bank's insurance premiums In fact, diversified portfolios with the prospect of higher return might actually lower premiums became overly a ggressive, loading its portfolio with high risk or nondiversified loans, would the entire portfolio be endangered, as opposed to individual loans. At that point, a private insurer would demand higher premiums and the bank would be forced either to charge r isky loan customers higher rates for their money or to reduce the overall risk exposure of its loan portfolio Only when a bank A private insurance system would result not in the disappearance of risky venture capital, but in its more even distribution amo n g the banking industry. Needless to say, some excessively risky enterprises, which now receive support from overly aggressive banks thanks to the subsidies of the FDIC premium structure would be unable to obtain funds. But this would be an accurate determ i nation by the market that the probable return from the venture did not justify its risk I What happens in the event of massive failures? The specter of 1930s-type bank failures still haunts the American public despite the many differences between the 1930 s and present-day banking. The manner in which a private insurance system would respond to widespread failures is, in fact, important. Public confidence in the system is crucial to its smooth operation, and the private insurance industry is as averse as an y other industry to losses due to widespread failures among its clients.

Today, the FDIC's resources fall far short of those that would be needed in the event of massive bank collapses. The failure of any significant number of banks would quickly deplete t he FDIC's $12.3 billion reserve fund and $3.0 billion line of credit with the Treasury. And at this juncture, neither the Federal Reserve System nor the Treasury Department would be required to do anything further. 18 It is a common assumption, however, t hat the Federal Reserve and the Treasury would extend support beyond their legal obliga tions in the event of a catastrophic series of bank failures.

Cannot the same assumption be made concerning a system of privately provided insurance? The federal government undoubtedly would take steps through one of the remaining banking agencies to support the financial system, should the need arise.

Professor George Kaufman of Loyola University, suggests that a trigger mechanism be used fail , say 100 or 200, the federal government would step in to pay depositors, releasing insurance companies from further obligations in a crisis situation. Alternatively, the trigger mechanism might be geared to the total asset size of failed banks allow more weight to be given to large banks since they place a greater strain on the insurance system when they fail.

First, it would reassure the public and the insurance industry that, in the unlikely event of massive structural failure, the federal government wo uld take final responsibility for supporting the system. Secondly, it would prevent the financial institutions or their insurers from asking for a "bail-outtt at the earliest sign of trouble. Pressure would not be easily mounted if the law stated explicit ly when the government was to step in Should a pre-set number of banks This would Such a trigger mechanism would serve a two-fold purpose.

Finally, it should be noted that, even without some sort of trigger mechanism, insurance companies would be willing t o take on the risks involved in insuring deposits. The argument that private insurers would not insure deposits because of the banking industry's alleged sensitivity to changes in the business cycle is unfounded. Banks have, in fact, weathered the vagarie s of the business cycle better than most businesses. Failures resulting from restrictive monetary or other government policy, could be viewed for insurance purposes as analogous to an !'act of God."

Casualty insurance companies continue to provide insuranc e for homes in coastal towns despite the chances that a hurricane could result in heavy payment requests. Furthermore, these companies do not expect to be released from their obligations simply because events beyond their control led to an extensive drain on reserves.

In short, private insurance companies would anticipate the possibility of a large bank failure through diversification and reinsurance--the same methods used to spread risks on other insurance contracts. Furthermore, in its role as "protector of the currency," the Federal Reserve System could be expected to step in with emergency aid in the event of a catastrophe just as it would now despite the absence of a statutory requirement that it do so. 19 5 CONCLUSION The current system of federally p rovided deposit insurance creates perverse incentives. It encourages excessive risk taking by banks and a lack of concern regarding banking practice among the larger, more sophisticated depositors. The logistics of insuring more than 14,000 banks has led to the substantial regula tion of these institutions. Richard Pratt, Chairman of the.

Federal Home Loan Bank Board, has pointed out the problem: As long as insurance premiums do not fit the banks' risk, banks must be regulated to fit a fixed insurance prem ium as the economy begins its recovery. They may lie dormant until another economic crisis, but the inherent defects of the existing system will continue to haunt the banks and savings and loan associations. American depository institutions must be freed i from the regulatory chains in which they are now confined. Other wise, rapid technological and economic changes will pass them by I leaving them to sell an antiquated product designed for the 1930s I slim chance of success without substantial reform of t h e deposit The troubles facing depository institutions will not disappear But widespread efforts to deregulate the industry face a insurance system more flexible banking system is the privatization of the deposit insurance function The only reform that can guarantee a saf'er and A move toward a private system is not a leap in the dark.

Money market funds do not have federal deposit insurance-=though many funds are covered by private insurance No other major government with a free banking system provides dep osit insurance for its banks. Credit unions in many states are beginning to move from a government-sponsored system to private deposit insur ance. Much is known from these experiences about the operation of a world without federal deposit insurance. Remov i ng the strong government influence on U.S. banking that stems from its unique federal deposit insurance system would bring the industry more in line with the rest of the world and the rest of U.S industry. Even government officials are beginning to admit that private sector insurance may be superior to the federal version.

At a conference sponsored by the Securities and Exchange Commission in early October, Federal Home Loan Bank Board Chairman Pratt suggested that a private deposit insurance system, with some sort of federal reinsurance, is an idea worthy of serious consideration.

On the same panel, C.T. Conover, Comptroller of the Currency agreed with Prattls suggestion.

The Depository Institutions Act of 1982 requires federal authorities to consider wa ys in which problems with the current system of deposit insurance might be solved. In this endeavor the FDIC must be recognized as a relic of a bygone banking age the banking industry should be allowed to enter the 1980s by dismantling the FDIC; and priva t e insurance companies 20 should be allowed to take over insuring of deposits-a task for which they are eminently more qualified than is the federal government FDIC has proved that, while it can rescue banks, it cannot prevent failures. A system of private insurance, marshalling time-tested market incentives will create an environment in which the malaise of shaky financial institutions can be detected early and restored to health I Catherine England John Palffy Policy Analysts