1. Class #16, Chap. 19

2. Purpose: to understand costs and benefits of depository insurance as well as how it is priced  Depository Insurance History ◦ Agencies; Structure; Limits  Problems with depository insurance (risk taking)  Controlling risk taking ◦ Stockholder discipline  Risk-based premiums  Capital adequacy ◦ Depository discipline ◦ Regulatory discipline 2

3. Milton Friedman on the Great Depression 3

4. Deposit Insurance History 4

5. 5 Bank Failures in the Great Depression From 1930 – 1933 = 10,000!!! From 1933-1942 = 390 As a result of bank failures during the Great Depression, President Roosevelt signed into law new banking regulation. The Glass-Steagall Act which contained provisions for federal depository insurance

6.  Federal Depository insurance: ◦ Commercial banks in 1933 as part of Glass-Steagall (1933) ◦ S&Ls in 1934 as part of the National Housing Act (1934)  Federal Deposit Insurance Company (FDIC) ◦ Founded in 1933 ◦ Insured deposits at commercial banks (initially $2,500)  Federal Savings and Loan Insurance Corp. (FSLIC) ◦ Founded in 1934 ◦ Insured deposits at Savings and Loans (initially $2,500) 6

7.  What was depository insurance supposed to do? ◦ 1930-1933 10,000 banks failed ◦ Deposit insurance was meant to stop bank failures by eliminating bank runs  All bank runs? 7 Are all bank runs bad?

8.  What was depository insurance supposed to do? ◦ 1930-1933 10,000 banks failed ◦ Deposit insurance was meant to stop bank failures by eliminating bank runs  All bank runs? Are all bank runs bad? ◦ No, unhealthy or failing banks weaken the economy ◦ The longer these banks are allowed to operate the more costly they are to liquidate.  Depository insurance was setup to stop contagious bank runs that caused insolvency at healthy DIs ◦ But deposit insurance does not distinguish between good and bad banks ◦ Relying on depositors to close bad banks is no longer an option 8

9. 9  Premiums were paid by banks as a percent of deposits held at the bank

10.  Depository Insurance: provided a government guarantee on a nominal amount of deposits ◦ Reduced the likelihood of bank runs (on both healthy and unhealthy DIs) ◦ Implemented centralized monitoring by the FDIC & FSLIC  Depository Insurance Providers ◦ FDIC - 1934 ◦ FSLIC – 1934  Depository Insurance Limit at Banks: Depository Insurance Limit at Banks: 10 YearLimit 19342,500 19355,000 195010,000 196615,000 196920,000 197440,000 1980100,000 2008250,000 State Depository Insurance existed before then but it was insufficient

11. 11 Very few bank failures from 1940s-1980s. Depository insurance reduced the risk of bank runs Does no bank failures mean that the financial sector was stable and healthy?

12. 12 1970s-1980s reduced monitoring by depositors along with deregulation allowed banks to take on excessive risk. By 1991the FDIC reserves were almost depleted. It was given special permission to borrow 30 billion from the US treasury. Even with the loan it ended 1991 with a $7 billion deficit  Depository insurance is not uniquely responsible for the S&L crisis  Deregulation and fraud played a much larger role

13.  1029 bank failures between 1980-1990  Bank liquidations were historically the most costly  FSLIC went bankrupt  FDIC was insolvent but receive taxpayer assistance  1989 Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) ◦ Restructured the FSLIC and placed it under the management of the FDIC ◦ The fund was renamed the Savings Association Insurance Fund (SAIF) 13 FDIC Commercial Bank Fund: Bank Insurance Fund (BIF) Savings Association Fund: Savings Association insurance Fund (SAIF)

14.  2006 the FDIC merged the two funds BIF and SAIF into one fund to form the Depository Insurance Fund (DIF)  As of 2009: 14 FDIC 6,995 Commercial banks with 4,054 Billion insured deposits 1,200 Savings institutions 759 Billion in insured deposits DIF

15. Problems with Depository Insurance Moral Hazard 15

16.  How would offering depository insurance cause a moral hazard problem that could lead to bank failures? 1. Allows DIs to borrow at the risk free rate (government backed) 2. Reduces depositors’ monitoring & punitive action ◦ Higher interest rates – risk premium ◦ Withdraw deposits – bank runs 3.Result: Banks have a stable and low cost source of financing (deposits) no matter how much risk they take Higher Risk = Higher Profits  Depository insurance gives banks incentive to take on more risk because they are not responsible for losses 16

17.  Questions: Does depository insurance always lead to a moral hazard problem? No! only if it is mispriced  Depository institution profit Π = R risky – R deposit – R insurance Constant with respect to bank risk Increases with bank risk 17 If the insurance premium does not increase with bank risk, the bank can increase profits by taking on more risk

18.  Questions: Does depository insurance always lead to a moral hazard problem? No! only if it is mispriced  Depository institution profit Π = R risky – R deposit – R insurance Increases with bank risk Constant with respect to bank risk Increases with bank risk Constant with respect to bank risk 18 ↑ $1 If the insurance premium increases with bank risk, then banks cannot increase profits by taking on more risk. So, there is no incentive to do so.

19. Controlling DI Risk Taking 19

20. 1. Increase stockholder discipline a)Insurance Premiums b)Implementing risk based premiums c)Increased capital requirements and stricter closure requirements 2. Increase depository discipline 1.Insured Depositors 2.Uninsured Depositors 3. Regulatory discipline 1.Examinations 2.Capital Forbearance 20

21. Increase stockholder discipline 21

22.  Historical premiums were a “flat rate” of deposits ◦ Originally, all banks paid 8.33% of deposits for FDIC/FSLIC insurance ◦ The rate was increased several times to cover shortfalls  Consequences of a flat rate fee: 22 Low Risk Banks High Risk Banks Insurance keeps borrowing costs deposit rates low for each group 1.Low-risk group makes safe investments, earns a lower rate and makes less profit. 2.Insurance premium is likely too high for this group and cuts into lower profits 1.High-risk group makes risky investments, earns a higher rate and makes more profit. 2.Insurance premium is likely too low for this group boosting their higher profits Low risk banks subsidize the risk- taking behavior of high-risk banks

23.  Risk-based premiums eliminate the subsidy to high-risk banks and reduce their incentive to take on excess risk. Methods for calculating risk-based premiums 1. FDIC tables 2. Options Pricing 23

24. Risk-Based Premiums 1. FDIC Tables 24

25. 25 Uses the same capital adequacy measures outlined in the Basel Accord Total risk based capital ratio ≥ 10% and Tier I risk-based capital ratio ≥ 6% and Leverage ratio ≥ 5% Total risk-based capital ratio ≥ 8% and Tier I risk-based capital ratio ≥ 4% and Leverage ratio ≥ 4%

26. 26 Example: Suppose a DI has a Tier I capital Ratio of 3.3% and was evaluated as Supervisory concerned in its last FDIC review. How much must it pay as a percentage of deposits for deposit insurance? Total risk based capital ratio ≥ 10% and Tier I risk-based capital ratio ≥ 6% and Tier I Leverage ratio ≥ 5% Total risk-based capital ratio ≥ 8% and Tier I risk-based capital ratio ≥ 4% and Tier I Leverage ratio ≥ 4%

27. Seattle National Bank (SNB) has a Tier I risk based capital ratio of 3.7%. Banking regulators classified SNB as healthy in its last FDIC review. What is SNB’s annual FDIC premium payment if it currently has $248M in deposits of which 93% are insured. 27

28. Risk-Based Premiums 2. Options Pricing 28

29. 29  Call Option ◦ The option to buy an asset some time in the future at a pre-specified price  Put Option ◦ The option to sell an asset some time in the future at a pre-specified price  FDIC Insurance: (How is it an option?) ◦ The FDIC has given bank owners (equity holders) the option to sell the firm at the point when it can no longer repay depositors.  Pricing Inputs ◦ What kind of option is this? ◦ What is the pre-specified price? FDIC has sold a Put Option Market value of assets = Insured deposits

30. 30 D DI insured Deposits DI asset value P = premium The DI does well and ends up with enough capital to payoff all depositors 1.FDIC receives the insurance premium only Options Pricing: The FDIC can view the insurance contract as selling the bank (depositors) an option to sell (put) its Assets DI does poorly and does not have enough capital to payoff depositors. 1.FDIC takes control of the bank 2.FDIC liquidates assets to payback depositors 3.Losses to FDIC (D-A)-P

31.  Given that FDIC insurance can be viewed as the sale of a put option, we can find the premium (value of the option) using the Black & Scholes formula D = value of insured deposits A = value of bank assets r = the risk free rate  volatility of returns on assets T = Time to maturity – (term of insurance) 31 X2X2

32. Example: Clintonville Community bank has insured deposits of $60M total assets of $75M and estimated asset return volatility of.17 pa. Find the total annual premium the FDIC should charge if the one-year risk free rate is 4%. 32 D = 60M A = 75M r = 0.04  0.17 T = 1 year Step #1 Calculate X 1 and X 2

33. Example: Clintonville Community bank has insured deposits of $60M total assets of $75M and estimated asset return volatility of.17 pa. Find the total annual premium the FDIC should charge if the one-year risk free rate is 4%. 33 Step #2 find Φ(X 1 ) and Φ(X 2 ) -1.6329 -1.4629

34. Find Φ(X 1 ) = -1.63 on the table: 1.0000 - 0.9484 0.0516

35. Example: Clintonville Community bank has insured deposits of $60M total assets of $75M and estimated asset return volatility of.17 pa. Find the total annual premium the FDIC should charge if the one-year risk free rate is 4%. 35 Step #2 find Φ(X 1 ) and Φ(X 2 ) -1.6329 -1.4629

36. Find Φ(X 2 ) = -1.46 on the table: 1.0000 - 0.9279 0.0721

37. Example: Clintonville Community bank has insured deposits of $60M total assets of $75M and estimated asset return volatility of.17 pa. Find the total annual premium the FDIC should charge if the one-year risk free rate is 4%. 37 Step #2 find Φ(X 1 ) and Φ(X 2 ) -1.6329 -1.4629

38. Example: Clintonville Community bank has insured deposits of $60M total assets of $75M and estimated asset return volatility of.17 pa. Find the total annual premium the FDIC should charge if the one-year risk free rate is 4%. 38 Step #3 find insurance premium The FDIC should charge Clintonville an annual premium of $292,671 for deposit insurance

39. Example: Consider a bank with 450 mill in insured deposits and total assets of 625 million. The volatility of the banks assets is.12 per annum. Currently the one-year risk free rate is at 2%. Calculate the annual insurance premium the FDIC should charge for depository insurance 39

40. Find Φ(X 1 ) = -2.96 on the table:

41. Find Φ(X 2 ) = -2.84 on the table:

42.  Regulators can also reduce the incentive to take risk by: 1.Requiring more equity capital 2.Requiring lower leverage (another way to measure capital ) 3.Imposing stricter DI closure rules  Why would 1 & 2 reduce the incentive to take risk 42  Equity capital is the value of equity holders’ claim on the firm’s asset  More equity capital means that equity holders (management) has paid for a larger fraction of the firm’s assets and have more to lose.

43. Increase Depositor Discipline 43

44.  Regulators can limit deposit insurance so uninsured depositors will: a)Require a risk premium b)Ration credit – pull deposits out of the banks  Uninsured Depositors ◦ Large – above 250K ◦ Influential – control larger fractions of the banks financing  FDIC Improvement Act (FDICIA) ◦ Made bank failures more costly for uninsured depositors – increase attention ◦ Failure Resolution Policy- Least Cost Resolution (LRC)  The FDIC must evaluate several failure resolution scenarios  Must choose the method that imposes the highest cost on uninsured investors (with the exception of too-big-to-fail institutions) 44

45. Regulatory Discipline 45

46.  There are two key areas that the FDIC can regulate to reduce risk taking (moral hazard)  Examinations: FDIC required improved accounting standards ◦ Working toward market value of balance sheet assets and liabilities making it easy to monitor DIs off-site ◦ Beginning in Dec 2009 annual on-site examinations of every DI ◦ Independent audits from private accountants were mandated  Capital Forbearance: more timely closure of failing DIs ◦ Introduced prompt corrective action zones ◦ Mandatory actions are required in each zone – including closure 46

47.  Depository Insurance History ◦ Agencies; Structure; Limits  Problems with depository insurance ◦ Excess risk taking – moral hazard ◦ Good banks subsidizing bad banks  Controlling risk taking ◦ Stockholder discipline  Risk-based premiums  Capital adequacy ◦ Depository discipline ◦ Regulatory discipline 47