Deposit Insurance and Risk Management of the U.S. Banking System: What is the Loss Distribution Faced by the FDIC?

We examine the question of deposit insurance through the lens of risk management by constructing the loss distribution faced by the Federal Deposit Insurance Corporation (FDIC). We take a novel approach by arguing that the risk management problem faced by the FDIC is similar to that of a bank managing a loan portfolio, only in the FDIC’s case the risk arises from the potential for loss of the individual banks in its portfolio. We explicitly estimate the cumulative loss distribution of FDIC insured banks using two variations of the Merton model and find that reserves are sufficient to cover roughly 99.85% of the loss distribution, corresponding to about a BBB+ rating. However, under different stress scenarios (higher correlations, fat-tailed bank returns, increased loss severity) that level can be much lower: approximately 96% corresponding to about a B+ rating.JEL classification: G210, G280.Any views expressed represent those of the author only and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.     

Federal Deposit Insurance,Regulatory Policy,and Optimal Bank Capital*

This paper seeks to explain the combination of explicit and implicit pricing for deposit insurance employed by the FDIC. Essentially, the FDIC sells two products—insurance and regulation. To span the product space, it must and does set two prices. We argue that the need to establish regulatory disincentives to bank risk-taking is the heart of the controversy over the adequacy of bank capital and that the ability to close risky banks before exhausting their charter value (i.e., the value of their right to continue in business) stands at the center of these disincentives and in front of the FDIC's insurance reserves.     

Open-bank assistance transactions and prompt corrective action

Open-bank assistance (OBA), provided to troubled banking institutions by the FDIC to prevent their failure, has been criticized extensively on grounds that closed-bank transactions, especially early closed bank transactions, are less expensive to the FDIC. This article analyzes a case in which OBA makes public policy sense, under conditions in which uncertainty is introduced into the valuation of a bank's nonperforming assets. Under such uncertainty, the FDIC may play a role by providing to the acquiror of the troubled institution essentially costless (to the FDIC) standby insurance on the ultimate workout values of the nonperforming assets. If properly structured, such an OBA transaction would meet critics' objections by minimizing FDIC cost and creating incentives for the early recapilization of troubled banks.     

Capital standard,forbearance and deposit insurance pricing under GARCH

We propose a multiperiod deposit insurance pricing model that simultaneously incorporates the capital standard and the possibility of forbearance. The model employs the recently developed GARCH option pricing technique in determining the deposit insurance value. Our model offers two distinctive advantages. First, it explicitly considers the implications of the strict enforcement on capital standard as stipulated in FDIC Improvement Act of 1991. Second, the use of the GARCH model allows us to capture many robust features exhibited by financial asset returns. By the GARCH option pricing theory, the value of a contingent claim is a function of the asset risk premium. This unique feature is found to be prominent in determining the bank's deposit insurance value. We also examine the effects of capital forbearance and moral hazard behavior in this multiperiod deposit insurance setting.     

Depositors' Welfare,Deposit Insurance,and Deregulation

We develop an analytical model to address the question of optimal deposit insurance policy and to examine the impact of deregulation on depositors' welfare and the soundness of the insurance system. We find that the optimal level of regulation depends critically on the functional relationship between risk and return. We show that in general deregulation of bank activities and/or of deposit rate ceilings will in volve tradeoff between depositors' welfare and the soundness of the insurance system. Our analysis also indicates that risk-sensitive premium and capital requirement schedules may not be efficient in managing the risk of banks.     

Premium setting and bank behavior in a voluntary deposit insurance scheme

This study analyzes the effect of premium rates on banks’ incentives to join a deposit insurance scheme and their incentives to invest in risky projects under a voluntary deposit insurance scheme. We find that in order to maximize social welfare, the insurance agency must either set the premium rate to be low so as to attract all banks to join the insurance scheme, or not to have the deposit insurance at all. However, the low premium rate in the voluntary scheme does not balance the budget of the deposit insurance. We also show that in the compulsory deposit insurance scheme, however, it is possible to impose an optimal premium rate that can balance the insurance agency’s budget and achieve the highest social welfare. The results also present the dominance of the compulsory scheme over the voluntary scheme in terms of maximizing social welfare and balancing the budget.

Pricing Risk-Adjusted Deposit Insurance: An Option-Based Model

This paper presents a methodology for arriving at empirical estimates of deposit insurance premiums from market data by using isomorphic relationships between equity and a call option, and insurance and a put option. The data utilizes the market value of equity to solve for the asset value and its volatility. Market perceptions of FDIC bailout policies are explicitly modeled so as to eliminate the bias in inverted values of assets and their volatility. Sensitivity analyses are performed to show that rank orderings based on premiums are robust to changes in specification, thus facilitating allocation of aggregate premium across banks.     

“Skewness and Stock Option Prices”, Hans Gerber and Bruno Landry,July 1997

We determine the optimal amount of life insurance for a household of two wage earners. We consider the simple case of exponential utility, thereby removing wealth as a factor in buying life insurance, while retaining the relationship among life insurance, income, and the probability of dying and thus losing that income. For insurance purchased via a single premium or premium payable continuously, we explicitly determine the optimal death benefit. We show that if the premium is determined to target a specific probability of loss per policy, then the rates of consumption are identical under single premium or continuously payable premium. Thus, not only is equivalence of consumption achieved for the households under the two premium schemes, it is also obtained for the insurance company in the sense of equivalence of loss probabilities.     

RISK-TAKING INCENTIVES OF BANKS AND RISK-ADJUSTED DEPOSIT INSURANCE

The manager of a depository institution is shown to exhibit risk-taking behavior under the current insurance arrangement. Perfect monitoring or risk-based deposit insurance would eliminate this incentive if information were symmetric between bank managers and the insuring agency. Absent symmetric information, it is shown that a recently suggested scheme, where insurers collect insurance premiums based on projected and actual risk levels, does not control the risk-taking incentive. The only way to control this incentive through insurance rates is to levy a relatively high premium, which is not actuarially fair.     

The Value of Bank Durability: Borrowers as Bank Stakeholders

We examine the value of bank durability to borrowing firms. The analysis is based on theoretical models of the asset services view of intermediation which imply that private information and associated relationship-specific activities are intrinsic to bank lending. We analyze share price effects on firms with lending relationships with Continental Illinois Bank during its de facto failure and subsequent FDIC rescue. We find the bank's impending insolvency had negative effects and the FDIC rescue positive effects on client firm share prices. We conclude that borrowers incur significant costs in response to unanticipated reductions in bank durability and thus are bank stakeholders.     

BANK REGULATIONS,CAPITAL STRUCTURE,AND RISK

The joint influence of the Federal Reserve's (Fed) discount window credit and reserve requirements and FDIC's deposit insurance on a bank's optimal capital structure and asset risk choices is analyzed. The specific seniority of such regulatory claims, and potentially strong negative correlation between bank asset classes, significantly alters our traditional view of such regulatory influences on bank behavior. I find that the discount window's presence does not always prompt bank risk taking and leverage, but it does partially offset such incentives under certain conditions. In addition to its cost, a reserve requirement provides the bank with an indirect subsidy that may encourage deposit funding. Thus, regulatory reforms, such as the FDIC Improvement Act of 1991, which curtail banks' access to the discount window, may not always be appropriate to resolve a bank's incentive for moral hazard behavior. The Fed's presence needs to be more comprehensively examined to design effective regulatory policy.     

The Impact of Risk-Based Premiums on FDIC-Insured Institutions

This paper examines the effect of a series of announcements leading to the approval of risk-based deposit insurance premiums on returns to stockholders of commercial banks. Utilizing risk-weighted capital ratios and measures of overall risk, we group banks according to one of the nine-tier insurance categories subsequently defined by the FDIC. During the period in which the new insurance system was considered and approved, we found that stockholders of well-capitalized, healthy banks experienced wealth changes significantly different from those experienced by less than well-capitalized, less than healthy banks. Although many argued the premium range in the initial insurance schedule was insufficient, the results show that this initial risk-basing marked an important change in the relative burdens imposed by FDIC insurance.     

An Incentive Approach to Banking Regulation

We examine the optimal design of a risk-adjusted deposit insurance scheme when the regulator has less information than the bank about the inherent risk of the bank's assets (adverse selection), and when the regulator is unable to monitor the extent to which bank resources are being directed away from normal operations toward activities that lower asset quality (moral hazard). Under a socially optimal insurance scheme: (1) asset quality is below the first-best level, (2) higher-quality banks have larger asset bases and face lower capital adequacy requirements than lower-quality banks, and (3) the probability of failure is equated across banks.     

Incentive problems in bank insider borrowing

Although bank insider abuses have been one of the most frequently cited causes of recent bank problems, the existing literature is surprisingly sparse in this area. The purpose of this article is to examine one element of insider abuse—the case of bank insider borrowing. In the context of the theory of financial intermediation, we propose a hypothesis that excessive insider borrowing creates substantial incentive problems and leads the bank to inferior performance. Our empirical analysis provides results consistent with this hypothesis. The policy implication of this article is that the regulatory agencies and especially the FDIC should carefully monitor banks with excessive insider borrowing to prevent an arbitrage against the insurance fund.     

Selling Failed Banks

The average FDIC loss from selling a failed bank is 28% of assets. We document that failed banks are predominantly sold to bidders within the same county, with similar assets business lines, when these bidders are well capitalized. Otherwise, they are acquired by less similar banks located further away. We interpret these facts within a model of auctions with budget constraints, in which poor capitalization of some potential acquirers drives a wedge between their willingness and ability to pay for failed banks. We document that this wedge drives misallocation, and partially explains the FDIC losses from failed bank sales.     

An analysis of FDIC failed bank auctions

This paper examines whether the sales mechanism used by the FDIC in failed bank auctions results in wealth transfers from the FDIC to the acquiring banks. We test this hypothesis by examining the returns to winning bidders in FDIC auctions. We find positive abnormal returns to these bidders. More importantly, we find a negative and significant relation between the returns to winning bidders and the number of bidders participating in the auction. This evidence suggests that the FDIC's auction procedures do generate wealth transfers.     

A hierarchical agency model of deposit insurance

This paper develops a hierarchical agency model of deposit insurance. The main purpose of the analysis is to propose a micro-founded model of deposit insurance schemes and study their effects on the behavior of depositors and the monitoring problem for a bank. This paper also characterizes a risk-based premium in equilibrium, and conducts a comparative statics analysis of depositors’ optimal actions. The results supply the basic theoretical foundation for designing deposit insurance schemes. Our findings are consistent with the empirical research on depositor behavior.     

税务征收体制下的社会保险费征管制度建设研究

我国社会保险费征管体制改革正在不断深入。当前,社会保险费征管仍存在制度设计有待完善、法律依据不够清晰的问题。本文基于税收征管视角,对社会保险费征管制度进行了重新审视,在全面梳理了制约社会保险费征管制度完善的限制性因素的基础上,从科学设置社会保险费征管前置程序、全面构建社会保险费征管的保障程序等多个方面,对将社会保险费征管融入税收征管流程的可行性进行了分析和探讨,以期为我国社会保险费征管制度的完善提供参考。     

Assessing the FDIC's premium and examination policies using ‘Soviet’ put options

The FDIC's total liability for insuring a bank's deposits during a fixed period diminishes as the frequency of examinations increases, since a marginally solvent bank can be closed while losses are small. The paper develops a technique for pricing the insurance liability over a fixed period during which there are multiple examinations. Under current policy most banks are examined annually and reviewed every six months, at which time the fees for insurance may be adjusted. Since the current schedule of fees allows only a narrow range and a few discrete levels, the FDIC typically retains some positive or negative residual liability in each six-month period and for the entire year. We show how to estimate this net liability. The calculations of total and net liability are illustrated for a sample of large banks.     

Deposit Insurance, Capital Adequacy Requirements and Interest Rate Dynamics

This paper examines the long run interaction among deposit insurance, bank deposit rates and capital adequacy requirements. Using analysis similar to the price discrimination model of Lott and Roberts (1991) we find that a competitive environment among banks would link the spread between insured and uninsured deposit rates to the size of the insurance premium. We also find that banks that choose to operate at the regulatory minimum capital level, would increase asset risk with increased capital requirements if (1) the implicit interest paid to insured and uninsured depositors is equally sensitive to changes in risk and capital adequacy and (2) the insurance premium is independent of the level of risk and capital adequacy. Under the present risk-based premium structure, asset risk has the potential to decline when the regulatory agency raises capital requirements. Finally, we examine the time series behavior of insured and uninsured interest rates to see if it is consistent with our theoretical model. We find that insured and uninsured rates, along with deposit insurance premiums, are cointegrated series as suggested by our model.