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Deposit insurance reform: What are the issues and what needs to be fixed? Mitchell Berlin, Anthony Saunders and Gregory Udell 財研一邱堅彰 R94723090 財研一顏甄慧 R94723008.

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Presentation on theme: "Deposit insurance reform: What are the issues and what needs to be fixed? Mitchell Berlin, Anthony Saunders and Gregory Udell 財研一邱堅彰 R94723090 財研一顏甄慧 R94723008."— Presentation transcript:

1 Deposit insurance reform: What are the issues and what needs to be fixed? Mitchell Berlin, Anthony Saunders and Gregory Udell 財研一邱堅彰 R94723090 財研一顏甄慧 R94723008 財研一陳玠瑋 R94723003

2 Agenda  Introduction  Why do we need deposit insurance reform?  Shareholder discipline  Depositor and creditor discipline  Regulatory structure, resources, and objectives  Conclusions

3 Introduction  Deposit insurance promotes moral hazard, which is major cause of present crisis.  2 reform proposals: Impose greater discipline on bank stockholders. Increase the disciplinary role of bank debtors (depositors).

4 Introduction  2 problems for existing deposit insurance: Flat premium structure based on the deposit size, instead of riskiness of a bank’s assets. Large banks are “too big to fail”  large banks can issue debt at near risk- free rate regardless of B/S quality.  the incentive is misleading!

5 Introduction  Potential problem: For depositors: guarantee claim of $100000 leads to little incentive to monitor. For stockholders:  limited liability stockholders tend to increase debt and invest in high risk assets.  If default, stockholders lose little capital and FDIC bears most cost of failure.

6 Why do we need deposit insurance reform?  Banking industry has become more riskier over the last decade. Thrift crisis cost tax payers over $500 billion. The size of bank failure in recent years jeopardizes the solvency of bank insurance fund.  Significant difference in risk taking among banks.

7 Why do we need deposit insurance reform?  Factors contributes to thrift’s risks: 1. Specialized and undiversified banks are especially subject to sector shock. 2. Thrifts lost their comparative advantage in traditional specialization, i.e. mortgage market.

8 Why do we need deposit insurance reform?  Current problems of commercial banks: 1. Market size shrunk in 1980s due to the migration of borrowers from intermediate market to capital market. 2. Increasing competition on both asset and liability sides reduced their comparative advantage.  Asset: migration deteriorates the credit quality of commercial loan portfolio.  Liability: money market mutual fund (MMMF) reduced commercial bank’s monopoly power in retail deposit market.

9 Why do we need deposit insurance reform?  Current problems of commercial banks: 3. Fragmented industry structure:  too many banks holding geographically and sectorally specialized portfolio.  A large number of small, inefficient banks

10 Why do we need deposit insurance reform?  Shocks and Lessons: Bank failure in different regions:  Southwest: the collapse of oil price.  Midwest: the collapse of agricultural land values.  Bank of New England: geographically specialized and undiversified portfolio strategy.

11 Why do we need deposit insurance reform?  Shocks and Lessons: Lessons from failed banks:  Fragmented and undiversified banks have more intrinsic risks.  Market structure in banking industry magnified intention for risk taking.  Current problems of commercial banks are due to competitive restrictions. Thus, the lift of interstate branching restrictions is the precondition for deposit insurance reform.

12 Why do we need deposit insurance reform?  Empirical evidence in moral hazard Keeton and Morris (1987):  Banks with high loan losses in mid-1980s tend to have abnormal high return in early 1980s.  Banks with high losses also display high risk in leverage, loan-asset ratio, etc.  The evidence suggests a pattern of deliberate risk taking and moral hazard.

13 Why do we need deposit insurance reform?  Empirical evidence in moral hazard Saunders, Strock and Travlos (1990):  Ownership structure is related to bank risk taking.  Stockholder-controlled banks tend to be riskier than managerially-controlled banks.  Stockholders tend to exploit FDIC contract by increasing risk, while managers tend to preserve reputation in labor market by decreasing risk.

14 Why do we need deposit insurance reform?  Empirical evidence in moral hazard Most convincing evidence is savings and loan crisis:  Large portion of S&L industry was economically insolvent (negative net worth) due to interest rate surge in 1981.  Moral hazard suggests the incentive to exploit the fixed-rate insurance contract should be more acute as net worth diminishes.  Implication: the least solvent thrifts should choose the riskiest portfolio strategies.

15 Why do we need deposit insurance reform?  Empirical evidence in moral hazard Empirical evidence from savings and loan crisis:  Failed thrifts had more real estate loans and direct equity investments than industry average.  Low capital level ratios in 1982 were associated with risky portfolio in 1985.  Banks with low capital level invested in more non- traditional assets.

16 Shareholder discipline  Capital adequacy and deposit insurance The purposes of capital adequacy  Sufficient to absorb expected and unexpected portfolio shocks  Reduce shareholders’ incentives to undertake risky investments  Therefore , deposit insurance will have only a residual role!

17 Shareholder discipline  Capital adequacy and deposit insurance The dilemma between safe banking and capital ratio  Too low? It doesn’t work!  Too high? Entry will become too costly and the industry will tend to contract!

18 Shareholder discipline  Capital adequacy and deposit insurance Some problems behind market values of net worth  Difficult for banks to mark many of their assets because of the absence of a secondary market  Securitization  Market value accounting don’t apply to those without a secondary market

19 Shareholder discipline  Capital adequacy and deposit insurance Some problems behind market values of net worth  Earnings of banks could become more volatile as realized gains and losses are passed through the income statement

20 Shareholder discipline  Capital adequacy and deposit insurance What if the path to bank insolvency is a jump process?  For example , a sudden catastrophic shock  The goal to close a bank at non-zero net- worth level wouldn’t be achieved

21 Shareholder discipline  The deposit insurance contract Risk-based & Incentive-compatible premium Solely linking to a bank’s balance sheet position at the the beginning of the assessment period A scheme linking end-of-period rebates or penalty charges and front-end (beginning of the period) premiums

22 Depositor and creditor discipline  2 Implications of the TBTF guarantee : An unfair competitive advantage potentially arises for large over small banks. It creates considerable risk-taking incentives among the largest U.S. banks.

23 Depositor and creditor discipline  3 mechanisms for imposing depositor and creditor discipline : Depositor preference Insured versus uninsured and depositor ‘haircuts’ The size of the cap

24 Depositor and creditor discipline  Depositor preference : Treat depositors and non-deposit creditors differently. All depositors (insured and uninsured) are treated equally and senior to other creditors and claimholders.

25 Depositor and creditor discipline  Depositor preference : Effects : to create incentives for non- deposit claim-holders of all size to monitor the bank. Weaknesses : there is still a significant guarantee for the large uninsured depositor.

26 Depositor and creditor discipline  Insured versus uninsured and depositor ‘haircuts’ : All insured deposits are transferred to another bank. Only a proportion uninsured deposits are transferred to another bank. The percentage is uncertain on a bank-by- bank basis. (the likely liquidation value of the failed bank’s assets.)

27 Depositor and creditor discipline  Insured versus uninsured and depositor ‘haircuts’ : Effect : This results in a bank-specific ‘haircut’ administered to the large depositors of failing banks.

28 Depositor and creditor discipline  Insured versus uninsured and depositor ‘haircuts’ :  If loss rate is fixed : Advantages : large depositors would know that they would lose a certain percentage of their deposits on any bank failure.

29 Depositor and creditor discipline  Insured versus uninsured and depositor ‘haircuts’ : Disadvantages :  Wealth transfer from safe to unsafe banks.  Risk-averse depositors may don’t have a great incentive to monitor bank risk.

30 Depositor and creditor discipline  The size of the cap : If the cap is high : decrease depositor discipline If the cap is low : increase depositor discipline  So some authors have argued that the cap, $100,000,should be decreased.

31 Depositor and creditor discipline  The size of the cap : Dreyfus, and Saunders(1990) have shown that over some range at least, lower caps may imply higher contingent liabilities to the insurance fund.

32 Regulatory structure, resources, and objectives  Externalities : Contagion effects or panics Asymmetric information lead to moral hazard or adverse selection.

33 Regulatory structure, resources, and objectives  What is the appropriate objective function for bank regulators : To provide fairly priced insurance for each bank subject to a zero profit constraint. (without externalities) Pay greater attention to optimal structure of the deposit insurance contract is clearly warranted. (with externalities )

34 Conclusions  The current insurance contract results in Moral hazard problems, so deposit insurance reform is necessary.  2 approaches to reforming the deposit insurance contract : To increase stock-holders discipline (information advantage) To increase debt-holders discipline (information disadvantage)


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