Deposit insurance reform: a functional approach

Carnegie-Rochester North-Holland

Conference Series on Public Policy 38 (1993) 41-50

Deposit insurance reform: functional approach

a

A comment George J. Benston Emory

University, Atlanta,

Georgia 30322, U.S.A.

and

George G. Kaufman Loyola

Me&on

Universi2yof Chicago, Chicago,

and

Bodie’s

IL 60611,

U.S.A.

proposal

Basically, Merton and Bodie argue that in banking, as in many other disciplines, form should follow function. Therefore, as banking performs two core functions - deposit-taking and loan-making - which, according to Me&on and Bodie have no important synergies, it would be rational to restructure our banking system so that some institutions have exclusively one function and others the other, but none do both. Deposits are defined as creditor funds that effectively are riskless. To achieve this property, deposit-accepting banks would be required to invest only in the shortest-term Treasury securities and their equivalent. By providing deposits that are free of credit and interest-rate risk, these “narrow” or “safe” banks would provide a service that Merton and Bodie claim is demanded by most depositors. The authors are not clear whether these deposits would be protected by deposit insurance against the risk of fraud and mismanagement. Loan-making banks would be knowingly risky and would attract creditors willing to assume the risk. These creditors need not be protected by federal deposit insurance. Th us, Merton and Bodie conclude that “by changing the institutional structure of commercial banking-through separating banks’ lending and loan-guarantee activities from their deposit-taking activities, it is possible to achieve potentially large social benefits with no apparent offsetting costs.” There are at least two important offsetting costs, however: lost 0167-2231/93/$06.00

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synergies Problems

and the cost of restructuring with

the

Merton-Bodie

proposal

Synergies from the common production Contrary

banking.

and consumption

of deposits and loans

to Merton and Bodie, the evidence strongly suggests that there are

significant synergies from deposit-taking, loan-making, and other financial services. Absent such synergies, how can one explain the joint production and consumption of these products since the beginnings of commercial activity in almost all countries and centuries ? Institutions that offer both deposit and savings services and loans (fund-using) have been and are the dominant financial institutions both in the United States and worldwide. This jointness existed before and with government regulation. Institutions specializing in either deposit-taking (e.g., money market funds) or loan-making (e.g., finance companies) are substantially less important in both size and service to consumers than are full-service commercial banks and thrifts. Furthermore, absent laws restraining the interest rates banks can pay on deposits (the Banking Act of 1933’s prohibition of interest on demand deposits and ceiling on time and savings deposits) and branch operations, and usury laws limiting interest rates that could be charged on loans, it is likely that these specialized institutions would be of even lesser importance. Indeed, from the experience of other countries and the United States before 1933, there is reason to believe that U.S. banks would offer a wider range of products (particularly investment banking and insurance) were they not restrained by law. It seems reasonable to assume, therefore, that these combinations are demanded by the marketplace and that there are economies of scope in their production. Furthermore, although commercial banks have been losing market share in the United States, this loss has not occurred in all countries and business has not been lost primarily to specialized depository or lending institutions. Indeed, considering the rapid advances in information technology in recent years that reduced the cost to nonbanks of entering banks’ markets, the detrimental effect on banks’ ability to compete when inflation increased market rates above deposit-rate ceilings, and the increasing direct and opportunity cost of regulation and product restrictions imposed on banks, the loss would most likely have been greater if synergies were not important. The costs of restructuring Collateralized deposits within a loan-making bank. The costs of breaking longstanding multifunction banks into two specialized institutions depend on how the new banks would be structured. Merton and Bodie appear to favor a 42

structure

that focuses on collateralizing

deposits with specified

“safe” assets

rather than dividing deposit-taking and loan-making into two legally and possibly even physically separate entities. This is not greatly different from a proposal of a Brookings Institution Task Force in 1989 of which we were both members (Benston et al., 1989). This structure would entail relatively low restructuring cost and a possibly small loss of potential synergies. Although Merton and Bodie do not refer to it, there is a precedent for such banks in U.S. history. Under the National Bank Act, national banks were required to collateralize their bank notes with Treasury securities. Thus, national bank notes, which were as much as one-half of Ml, effectively were federally insured (Kaufman, 1987). Banks could make loans as long as their holdings of Treasuries did not drop below the amount of their notes outstanding, but these loans had to be funded with deposits and equity investments that were at risk. In any event, there was no loss of potential synergies from combined note or deposit-issuing and loan-making. This structure could be closely replicated in today’s environment by requiring collateralization of all deposits by “safe” securities, with loans made in the same bank funded entirely by subordinated debt. To avoid a number of potential problems that Merton and Bodie discuss, the debt must contain covenants that make it legally junior to the FDIC. So that debt-holders could not run and uninsured creditors rather than the FDIC would absorb loan and other losses, subordinated debt also must have remaining maturity of at least one year and provisions forbidding it to be redeemed, directly or indirectly, by banks prior to maturity. Such a structure would generate substantially lower costs than if deposit-taking and loan-making activities were separated legally by fire walls or conducted in physically as well as legally distinct organizations. Deposit collateralization and loans and investments funded entirely with subordinated debt give rise to at least three types of costs. Merton and Bodie would restrict the collateral to short-term U.S. Treasuries. Banks would have to hold a sufficiently large amount of these securities to cover deposits. At year-end 1991 there were outstanding $750 billion of marketable Treasury securities maturing in less than one year compared to approximately $2,000 billion in insured deposits. Thus, either the Treasury would have to issue more bills, or other securities (such as commercial paper) would have to be used as collateral, which would increase monitoring costs. In any event, the earnings on the collateral probably would be insufficient to provide banks with sufficient revenue to pay the cost of providing deposit services (particularly check-clearing). Hence, depositors would have to pay rather than be paid to keep their funds with a bank, It seems likely that alternative suppliers of funds transfer services would arise (such as Merrill Lynch) who invest in less safe securities and charge lower rates (or even pay 43

interest on balances) to “depositors” for the same services. A second cost arises from the consequence of political pressure on the government by “depositors” in these firms who would want to be bailed out should the firms fail with losses that exceed their capital. Alternatively, the government might monitor and supervise these firms, which brings us back to where we are now. The third cost results from the pressure that government would face, should a bank fail, to bail out the subordinated debt-holders. The holders of this debt (which is likely to be a substantial portion of a bank’s liabilities) might argue that they thought they were insured depositors, despite notification to the contrary. If the subordinated debt were sold in relatively small amounts to many investors at the same location as bank deposits were accepted, this argument would be hard to withstand politically. Indeed, such has been the experience in many countries in addition to the United States.’ Legal and physical separation. Separating existing banks into legally and physically separate companies that either provide deposit or loan services would be very costly. New structures would have to be built or old structures redesigned. Employees who provide customers with relationship banking would have to be assigned to each organization. Customers would have to incur the cost of dealing with and providing information to each organization. It seems clear that this alternative would be very expensive both to banks and to customers. As a result, it seems likely that alternative suppliers of total banking services would gain a competitive advantage and would attract a substantial number and volume of business from the specialized banks. An additional expense, then, is the expected cost to taxpayers if the government were to bail out depositors in some of those noninsured alternative “banks” that fail with losses that exceed capital. A less-costly

solution

Fortunately, there is a less-costly and disruptive solution to the deposit insurance problem that does not require modifying the existing institutional structure. This reform was first developed by us for an American Enterprise Institute task force in 1987 (B enston and Kaufman, 1988), expanded by the Shadow Financial Regulatory Committee in 1989 (reprinted in Journal of Financial Services Research, 1992), supported in a Brookings Institution task force study in 1989 (B enston, et al., 1989), accepted in part by the U.S. Treasury in its banking reform proposal in early 1991 (U.S. Treasury Department, 1991), and incorporated in part in the Federal Deposit Insurance Corporation Improvement Act (FDICIA, PL 102-242) signed by the Presi‘See Kane and Kaufman (1992) for a description of a state government bailout “depositors” in a large Australian building society (savings and loan) that failed.

44

of

dent at year-end 1991, only a scant four years after it was first developed. Thus, structured early intervention and resolution is now the law of the land. The Ben&on-Kaufman

proposal

Bank capital would include equity and all debt that is explicitly not guaranteed by the deposit insurance agency or government and that cannot be repaid by the bank before the supervisory agencies can act. Subordinated debentures with present maturities of at least one year fit this requirement. If these debentures are publicly traded, the market rates of interest on these obligations can provide bank supervisors with early warning signs of banks’ financial difficulties. Closely-held banks probably would find placing subordinated debentures with investors (such as pension funds, insurance companies, and other banks) preferable to selling stock that might dilute the control of present owners or that could not be sold to investors who would be minority stockholders. Most important, allowing banks to hold subordinated debentures as capital puts them in the same situation as other corporations with respect to their cost of capital. Hence, requiring banks to hold higher levels of capital (defined as being explicitly uninsured) up to the amount that the market would demand in the absence of deposit insurance does not impose higher costs on them, with the exception of reducing or removing a subsidy due to underpriced deposit insurance. In effect, banks would only be required to hold explicitly uninsured debentures in place of insured certificates of deposit. In addition, capital should be measured in terms of economic market values. However, the proposed scheme also can be effective when capital is measured according to traditional accounting values. Four explicit, predetermined ranges or tranches of capital-to-asset ratios would be specified. ’ Assets would include off-balance sheet accounts, but assets would not be classified according to risk because of the difficulties in measuring ex ante risk accurately. 1. Banks are considered to have adequate capital if it is, say, 10 percent or more of their total assets, preferably measured in terms of market or current values. Those falling into this first tranche would be subject to minimum regulation and supervision. 2. Banks with capital-to-asset ratios of, say, 6 to 9.9 percent would be at the first level of supervisory concern. A bank in this second tranche would be subject to increased regulatory supervision and more frequent monitoring of its activities. It would be required to submit a business plan to raise more capital. At its discretion, the supervisory authority 2The material that follows is taken largely and often verbatim from the Shadow Financial Regulatory Committee, 1992.

45

could require the bank to suspend dividend payments

and obtain

proval before transferring funds within a holding-company could restrict the bank’s asset growth. 3. The

third

tranche

is the second

level of supervisory

ap-

system and

concern;

it is

reached when a bank’s capital ratio falls below six percent and is at least three percent. Banks in this range would be subject to intense regulatory supervision and monitoring. The supervisory authority would be required to suspend dividends, interest payments on subordinated debt, and outflows of funds to the bank’s parent or affiliates. The institution would have to submit an emergency plan for its immediate recapitalization to the tranche-one level. 4. Finally, when a bank’s capital falls below 3 percent of its assets, it would be in tranche four - mandatory recapitalization and reorganization. The supervisory authority must place the bank in a conservatorship, which would be charged with recapitalizing the bank or liquidating it in an orderly fashion within a short period by merger or sale of individual assets. The present owners and subordinated debt-holders would have the option of implementing quickly the plan submitted when the institution moved into tranche three, or of electing not to inject additional funds into the bank. If the owners and debt-holders elect not to recapitalize the bank, any residual value from its sale or liquidation of its assets would be returned to them, after allowing for costs incurred. The proposed scheme offers several advantages. One is that market forces are likely to correct a deteriorating situation before the supervisory authorities are forced to intervene. Wh en a bank falls into the second tranche, the authority can restrict its growth and payments to capital-holders. These restrictions should give capital-holders considerable incentives to take corrective action

while they still have investments

with positive

values.

Hence, it

is likely that the authority will not have to intervene further and the number of failures should be dramatically reduced. However, if, despite the intervention, the bank continues to deteriorate, or if conditions move so fast that the bank falls directly into the third tranche, the authority would be required to impose more severe sanctions and prevent fund flows to capital-holders. If, nevertheless, a bank drops to the fourth tranche, the authority would not be permitted to forbear from taking it over. Thus, if the scheme were adopted, the problem of incompatible regulatory incentives would be solved. Although some degree of supervision and deposit insurance would be continued, the cost would be trivial compared to the present system or to that proposed by Merton and Bodie. 46

By definition,

if any firm is recapitalized

or liquidated

before its economic

net worth becomes negative, losses accrue only to shareholders, not to depositors, other creditors, or the FDIC. Deposit insurance effectively becomes redundant, except for fraud and inadequate monitoring. Moral-hazard behavior of banks to assume excessive risk and of regulators to forbear insolvent or near-insolvent insured institutions is greatly reduced, without significant social or economic (deadweight) costs. effective deposit-insurance reform. The FDIC

Improvement

FDICIA

thus is major and potentially

Act’s provisions

FDICIA follows the above proposal closely. the existing $100,000 coverage per account,

It maintains deposit insurance at but requires among other things:

1. insured institutions to hold higher private capital ratios, more in line with what the market would require in the absence of insurance; 2. regulators to intervene promptly in a structured fashion when an institution begins to encounter financial difficulties to attempt to persuade it to reverse its course while there still is time by imposing progressively higher costs on poor performance through progressively harsher and more mandatory sanctions as performance deteriorates; and 3. recapitalization or liquidation of severely troubled institutions that do not reverse their course in time before the institution’s net worth is completely depleted; recapitalization would be by current shareholders or by sale to new shareholders. FDICIA specifies five rather than our four capital zones and imposes less severe, less mandatory, and less rapid regulatory responses than we propose. In addition, FDICIA requires mild risk-based insurance premiums. Less important

differences

with Merton

and Bodie

We also differ with Merton and Bodie on a number of less-important issues. Bank loans are less opaque than Merton and Bodie claim and reasonable market values may be estimated for them. Generally-accepted accounting principles (GAAP) require banks (and other businesses) to adjust book values for potential losses from default when such losses become probable. The divergence between GAAP and current value results from nonrecognition by GAAP of the effects of delay in cash flows even when there is no expected loss of principal and of changes in interest rates. Current values could and should be determined by discounting projected cash flows, which banks can and usually do readily determine. This is the procedure presently followed 47

for junk bonds, which are at least as opaque as most bank loans; bond funds now are routinely valued daily even if they are not traded daily, weekly, or even monthly. Marketable securities could readily be recorded at their market values. Thus, most bank assets could be recorded at current values. Merton and Bodie note that “the costs-both private and social-of setting capital requirements at the wrong level can be substantial.” We agree that the costs of setting capital requirements too low has been costly. But they also claim setting the levels too high also would be costly. We disagree, for three reasons. First, even if higher levels of capital were costly for reasons other than a bank’s losing a subsidy from underpriced deposit insurance, the requirement would have to be higher than the level the market would require in the absence of deposit insurance. This level can be gauged from the capital ratios of the banks’ financial competitors, such as finance and insurance companies, which have capital ratios two to four times the current level of commercial banks. Second, capital costs would be higher only if the requirements did not permit subordinated debt to be counted fully as capital, to the extent that banks would be forced to pay higher income taxes. Third, if banks were forbidden to offer some services (such as those related to securities and insurance), they might be forced to use their capital in suboptimal ways. Conclusion Our proposal would allow banks to offer whatever services they wished, as long as they maintained sufficient capital to absorb most of the losses they might incur. It provides for structured early intervention that reduces the cost of regulatory supervision and resolution and obviates the need for restrictive regulations. We suggest that this scheme (which is similar to that adopted by FDICIA) ac h ieves all that Merton and Bodie want but at a much lower social and economic cost. Before opting for major and costly institutional changes, it would be more efficient to put the objectives of FDICIA into operation and give the Act a chance to work before trying to change the law again.

48

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