Balancing Financial Stability and Enforcing Market Discipline: The Deposit Insurers Dilemma Don Inscoe Deputy Director Division of Insurance and Research FDIC IADI & TMSF June 27, 2007

2 Balance between Depositor Protection and Moral Hazard The Trade-offs There are two resolution strategies that illustrate how failed bank creditors are treated very differently: No Government Protection with full market discipline Full Government Protection with maximum moral hazard

3 Balance between Depositor Protection and Moral Hazard Balancing Act  Deposit insurers can strike a balance between these two extremes by: Maintaining liquidity by protecting insured depositors. Mitigating moral hazard by proving that resolution authorities are willing to impose any loss on uninsured depositors and creditors.

4 FDIC's Experience  Over its history, FDIC has taken different approaches to protect uninsured creditors, maintain stability in the financial system, impose market discipline, and mitigate moral hazard  Most of the banks closed by the FDIC during its history have been quite small by today’s measures and few have had systemic implications for financial stability or the economy  Since 1991, FDIC’s ability to protect uninsured creditors has been limited by “systemic risk exception” requirements

5 FDIC's Experience The Early Years ( )  1934 all failures were paid out, no uninsured creditors were protected.  Resolutions where uninsured creditors were fully protected increased as a percentage of failures from 1935 to  This policy of 100% protection for all creditors (insured and uninsured) continued until a “cost test” was put in place in From 1955 to 1968 uninsured creditors suffered losses in more than 80 percent of all failures.

6 FDIC's Experience 1968 – 1991  By 1968 FDIC had again shifted practices and full protection of uninsured depositors and creditors again became the dominate form of resolution

7 FDIC's Experience Deposit Insurance Determinations Paying Insured Deposits Only  Deposit insurance determinations required manual examination of all deposit account records.  If an account appeared be partially uninsured the account would be put aside to consult the depositor.  Typically FDIC would close a bank on Friday and all work would be done over the weekend so that customers could receive their insured deposit on Monday morning.  This manual process meant that there was a practical limit to the size of a failed bank that could be quickly closed.

8 The Number of Accounts in the Largest Banks Makes Rapid Insurance Determinations Difficult Largest Banks (June, 2006)Largest Insurance Determinations Name Domestic Deposits (Billions) Number Of DepositsName Deposits (Billions) Number Of Deposits Citibank1388,824,096First City Houston, NA2.5322,983 Bank of America56450,587,399First City Dallas, NA1.3172,047 JP Morgan Chase43517,648,660Hamilton Bank, NA1.331,546 Wachovia30622,740,254Southern Pacific Bank119,038 Wells Fargo & Company29930,396,923Keystone NB0.8824,215 Deposits and Deposit Accounts for the Five Largest Commercial Banks and Five Largest Insurance Determinations

Present FDICIA Limits FDIC’s Ability to Protect Uninsured Creditors The Least Cost Test and the Systemic Risk Exception  With the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991 Congress mandated that FDIC would encourage market discipline through: Prompt Corrective Action (PCA) The Least Cost Test, and The Systemic Risk Exception

10 FDICIA Limits FDIC’s Ability to Protect Uninsured Creditors  The Least Cost Test (Cost Test) requires: FDIC to calculate the costs for performing a payout of insured depositors Compare that cost to other resolution methods and choose the “least cost” resolution. In practical terms, uninsured depositors and creditors usually suffer losses when a bank fails.

11 FDICIA Limits FDIC’s Ability to Protect Uninsured Creditors The Least Cost Test and the Systemic Risk Exception  The Systemic Risk Exception allows the FDIC to bypass the least cost method if: it "would have serious adverse effects on economic conditions or financial stability" and if bypassing the least cost method would "avoid or mitigate such adverse effects.“ The systemic risk exception requires the approval of two thirds of the members of the FDIC's Board of Directors Two thirds of the members of the Board of Governors of the Federal Reserve System and the Secretary of the U.S. Treasury, who must first consult with the President.

12 Larger Banks are More Likely to Pose Systemic Risk 10 Largest Banking Organizations Banks with Assets < $1 Billion (7,995 banks or 92%)

13 Steps FDIC is Taking to Meet Challenges  Congress has made clear that use of the systemic risk exception should be avoided if at all possible.  Therefore, FDIC is taking a number of steps to have the capacity to: Take over a systemically important bank Impose losses on uninsured depositors and creditors and have the bank open for business as usual by the next business day.

14 Growing Reliance on Uninsured Creditors More Likely to Raise Systemic Concerns

15 Steps FDIC is Taking to Meet Challenges  The FDIC has issued a proposal that would require large banks to maintain their records in such a manner that would: Allow the orderly take over of a large bank Identify possible uninsured depositors and place a hold on a portion of the deposits Provide immediate access to all insured deposits, and a large percentage of uninsured deposits Allow for the bank opening the next business day with full services for full range of bank customers.  We believe that a system similar to this proposal could provide for a viable resolution of large, systemically important banks, while containing moral hazard.

16 Steps FDIC is Taking to Meet Challenges For example, if a large bank failed: A provisional hold could be placed on all accounts over $100,000. The amount of the hold would reflect FDIC’s anticipated losses: For example, if anticipated losses equal 5 percent of assets, FDIC would hold $5,000 of a $200,000 deposit account. In this example, the depositor would have immediate access to $195,000.

17 Steps FDIC is Taking to Meet Challenges Summary  Large bank resolution planning activities  Provisional hold capability for banks with the most deposit accounts  Modernizing systems to enable FDIC to impose losses on uninsured depositors and provide timely access to funds  Ability to price large bank insurance assessments to reflect “exposure at failure”