Deposit insurance reform:
What are the issues and what need s to be fixed?
Mitchell Berlin, Anthony Saunders and Gregory Udell
財研一邱堅彰 R94723090 財研一顏甄慧 R94723008
Agenda
Introduction
Why do we need deposit insurance reform? Shareholder discipline
Depositor and creditor discipline
Regulatory structure, resources, and
objectives
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
Introduction
2 problems for existing deposit insurance
:
Flat premium structure based on the depos
it size, instead of riskiness of a bank’s asse ts.
Large banks are “too big to fail”
large banks can issue debt at near risk-f ree rate regardless of B/S quality.
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.
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.
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.
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.
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.
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.
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
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
Why do we need deposit
insurance reform?
Empirical evidence in moral hazard
Saunders, Strock and Travlos (1990):
Ownership structure is related to bank risk tak
ing.
Stockholder-controlled banks tend to be riskie
r than managerially-controlled banks.
Stockholders tend to exploit FDIC contract by
increasing risk, while managers tend to prese rve reputation in labor market by decreasing r isk.
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.
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
Shareholder discipline
Capital adequacy and deposit insurance The purposes of capital adequacy
Sufficient to absorb expected and unexpec
ted portfolio shocks
Reduce shareholders’ incentives to undert
ake risky investments
Therefore ， deposit insurance will have o
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!
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
Shareholder discipline
Capital adequacy and deposit insuranc e
Some problems behind market values of net worth
Earnings of banks could become more vola tile as realized gains and losses are passed through the income statement
Shareholder discipline
Capital adequacy and deposit insuranc e
What if the path to bank insolvency is a j ump process?
For example ， a sudden catastrophic shoc k
The goal to close a bank at non-zero net-w orth level wouldn’t be achieved
Shareholder discipline
The deposit insurance contract Risk-based & Incentive-compatible premiu
m
Solely linking to a bank’s balance sheet po
sition at the the beginning of the assessme nt period
A scheme linking end-of-period rebates or
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
Depositor and creditor discipline
3 mechanisms for imposing depositor an
d creditor discipline ：
Depositor preference
Insured versus uninsured and deposit
or ‘haircuts’
Depositor and creditor discipline
Depositor preference ：
Treat depositors and non-deposit cred
itors differently.
All depositors (insured and uninsured)
are treated equally and senior to other creditors and claimholders.
Depositor and creditor discipline
Depositor preference ：
Effects ： to create incentives for non-depo
sit claim-holders of all size to monitor the b ank.
Weaknesses ： there is still a significant gu
Depositor and creditor discipline
Insured versus uninsured and depositor ‘
haircuts’ ：
All insured deposits are transferred to anot
her bank.
Only a proportion uninsured deposits are tr
ansferred to another bank.
The percentage is uncertain on a
Depositor and creditor discipline
Insured versus uninsured and depositor ‘
haircuts’ ：
Effect ： This results in a bank-specifi
c ‘haircut’ administered to the large de positors of failing banks.
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 pe rcentage of their deposits on any bank failure.
Depositor and creditor discipline
Insured versus uninsured and depositor ‘
haircuts’ ：
Disadvantages ：
Wealth transfer from safe to unsafe
banks.
Risk-averse depositors may don’t h
Depositor and creditor discipline
The size of the cap ：
If the cap is high ： decrease deposito
r discipline
If the cap is low ： increase depositor
discipline
So some authors have argued that the c
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 th e insurance fund.
Regulatory structure,
resources, and objectives
Externalities ：
Contagion effects or panics
Asymmetric information lead to moral
Regulatory structure,
resources, and objectives
What is the appropriate objective functio
n for bank regulators ：
To provide fairly priced insurance for each
bank subject to a zero profit constraint. (wit hout externalities)
Pay greater attention to optimal structure o
f the deposit insurance contract is clearly w arranted. (with externalities )
Conclusions
The current insurance contract results in Moral
hazard problems, so deposit insurance reform i s necessary.
2 approaches to reforming the deposit insuranc
e contract ：
To increase stock-holders discipline
(information advantage)
To increase debt-holders discipline
