How to Charge for Deposit Insurance

We stand at interesting crossroads. It is clear the world over that the financial sector is in for more regulation from central banks and governments. Bold plans are being proposed for resolving the distress of systemically risky institutions, expanding the perimeter of regulation to hedge funds, setting standards for compensation structures, and enhancing the transparency of derivatives and other off-balance-sheet activities. Will these plans work? It depends on the details of their execution.

Yet, one omission is striking even at the blueprint stage: There is little recognition, if any, that a large number of explicit guarantees—in effect, subsidies—still exist for the financial sector. These include, most notably, deposit insurance and the recently provided temporary guarantees for debt issuance offered to banks as a result of the financial crisis. Charging the financial sector for these guarantees in a manner that preserves financial stability ought to be on the regulatory agenda. That would require measuring and charging for the direct costs to taxpayers and indirect costs due to induced incentives for banks to take excessive risks.

This paper provides a basic introduction on how to charge for one such guarantee – the government provision of demand deposit insurance to banks—and offers an assessment of the current scheme for charging of such insurance in the United States.

Banks are funded to a large extent by short-term liabilities called “demand deposits”. Providers of deposits choose to roll these deposits over each day in the sense that they have the right to demand that their deposits be paid back at any point in time. Such demand deposits are explicitly or implicitly insured in most countries of the world up to some threshold amounts per individual (or deposit account). Furthermore, during the current financial crisis many countries, most notably Australia and New Zealand, introduced deposit insurance for the first time, whereas a significant majority increased their insurance coverage. To provide for deposit insurance when it is triggered, it is common in most developed countries to have a deposit insurance “fund” although regulators in some countries only realized the need to set up such a fund during the current crisis. The capital of deposit insurance funds—which will be needed in case an insured bank cannot meet its depositor’s demands—is essentially the reserve built up over time through collection of insurance premiums from insured banks.

Given the relatively vast quantity of deposit insurance offered globally to the banking sector, it would seem natural that much thought must have gone into how governments or regulators should charge banks a premium for this insurance. It is thus rather surprising that most countries’ funds have no insurance premium being charged and the few countries whose funds do charge a premium, such as the United States, do so in a manner that is not sufficiently risk-sensitive, and unfortunately pro-cyclical, so that the funds are almost certain to be strapped for capital when insurance claims materialize.

To help address these limitations in future regulatory reforms, we lay out three simple rules for how deposit insurance premium should be charged:

1. The premium should be sensitive to the risk of individual banks but also to systemic risk; that is, it should increase not only as individual bank failure risk increases but also, crucially, as the joint bank failure risk increases;
2. The premium for large banks should be higher per unit insured deposit compared to small banks; and,
3. The premium should be charged not just to be actuarially fair—that is, to ensure that the fund breaks even on average—but also to discourage moral hazard associated with the insurance. In particular, to discourage banks from acting as herds and creating excessive systemic risk, the premium should charge more for systemic risk than what the actuarially-fair premium would.

Our first and most basic prescription is that the extent of systemic risk in the financial sector is a key determinant of efficient deposit insurance premiums to be charged to insured banks. The argument is as follows. When a bank with insured deposits fails, the deposit insurance fund takes over the bank and sells it as a going concern or piecemeal. During periods with widespread bank failures, it is difficult to sell failed banks at attractive prices since other banks are also experiencing financial constraints (Shleifer and Vishny, 1992). Hence, in a systemic crisis, the deposit insurance fund suffers from a low recovery from liquidation of failed banks' assets. This, in turn, leads to higher draw-downs per insured deposit.

Also, the failure of large banks leads to greater fire-sale discounts and higher draw-downs from the insurance fund per insured deposit. In addition, the fire-sales problem has the potential to generate a significant pecuniary externality that can have adverse contagion-style effects on other banks and the real economy (compared to effects stemming from the failure of smaller banks). Hence, the resolution of big banks is more costly for the deposit insurance regulator, directly in terms of losses from liquidating big banks and indirectly from contagion effects.

Finally, bank closure policies reflect a time-inconsistency problem (Mailath and Mester, 1994; Acharya and Yorulmazer, 2007, 2008). In particular, the regulators would ex ante like to commit to be tough on banks when there are wholesale failures to discourage them from ending up in that situation. However, this is not credible ex post and the regulators invariably show greater forbearance during systemic crises. While such forbearance has featured in the ongoing crisis from most regulators around the world, it has a strong set of precedents.¹ However, it is also true that such forbearance is costly ex post due to the fiscal costs of government intervention during crises. And such forbearance during systemic crisis is also costly ex ante as it creates a collective moral hazard whereby banks have incentives to herd and become interconnected so that, when they fail, they fail with others and increase their chance of a bailout.²

While our three principles for determining efficient deposit insurance premiums apply generally, it is useful to consider them in the context of how premiums have been priced in the United States. To this end, we provide below a discussion of the Federal Deposit Insurance Corporation (FDIC), the deposit insurance regulator, and the premium schemes that have prevailed so far in the United States.³

As a response to the devastating effects of the Great Depression, to insure deposits of commercial banks and to prevent banking panics, the FDIC was set up in 1933. The FDIC's reserves began with a $289 million capital injection from the US Treasury and the Federal Reserve in 1934. Through most of FDIC's history, the deposit insurance premiums have been independent of the risk of banks, mostly due to the difficulty in assessing banks' risk. During the period 1935–1990, FDIC charged flat deposit insurance premiums at the rate of approximately 8.3 cents per $100 insured deposits. However, starting in 1950, some of the collected premiums started being rebated. The rebates have been adjusted to target the amount of FDIC reserves in its Deposit Insurance Fund.

While the banking industry usually wanted deposit insurance assessments to be set at a relatively low level, FDIC wanted premiums to be high enough that the reserves could cover future claims from bank failures. In 1980, the assessment rate for the Deposit Insurance Fund varied between 1.1% and 1.4% of total insured deposits. As a result of the large number of bank failures during the 1980s, the Deposit Insurance Fund became depleted and the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) mandated that the premiums be set to achieve a Designated Reserve Ratio (DDR) of reserves to total insured deposits of 1.25%. Figure 1 shows the total deposits insured by the FDIC and Figure 2 shows the balances of Deposit Insurance Fund and the reserve ratio for the period 1990-2008.

The bank failures of the 1980s and early 1990s led to reforms in the supervision and regulation of banks such as the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991 that introduced several non-discretionary rules. In particular, FDICIA required the FDIC to set risk-based premiums, where premiums differed depending on three levels of a bank's capitalization (well-, adequately-, and under-capitalized) and three supervisory rating groups (rating 1 or 2, rating 3, and rating 4 or 5).

However, the new rules have not been very effective in discriminating among banks. During 1996–2006, over 90% of all banks were categorized in the lowest risk category (well-capitalized, rating 1 or 2). Further, FDICIA and Deposit Insurance Act of 1996 specified that if the Deposit Insurance Fund reserves exceed the Designated Deposit Ratio of 1.25%, the FDIC was prohibited from charging any insurance premiums to banks in the lowest category. During the period 1996–2006, the Deposit Insurance Fund reserves were above 1.25% of insured deposits and the majority of banks were classified in the lowest risk category and did not pay for deposit insurance.

The Federal Deposit Insurance Reform Act of 2005 (FDIRA) brought some changes to the setting of insurance premiums. In particular, instead of a hard target of 1.25%, the Designated Deposit Ratio was given the range of 1.15% to 1.50%. When the reserve ratio exceeded 1.50% (1.35%), 100% (50%) of the surplus would be rebated to banks. If the reserve ratio falls below 1.15%, the FDIC must restore the fund and raise premiums to a level sufficient to return reserves to the reserve ratio range within five years.

During the crisis of 2007–2009, the reserves of the Deposit Insurance Fund have been hit hard. The reserves did fall to 1.01% of insured deposits on June, 30, 2008, and they decreased by $15.7 billion (45%) to $18.9 billion in the fourth quarter of 2008, plunging the reserve ratio to 0.4% of insured deposits, its lowest level since June 30, 1993. Indeed, at such capitalization, even relatively small bank failures such as the Silverton Bank in Atlanta, Georgia and Bank United in Florida (with respectively around $4 billion and $12 billion in assets) threatened to wipe out the fund’s reserves unless ready buyers were found in the private sector. In the first week of March 2009, the FDIC announced that it planned to charge 20 cents for every $100 insured domestic deposits to restore the Deposit Insurance Fund. On March 5, 2009, Sheila Bair, Chairperson of FDIC, said her agency would lower the charge to around 10 basis points if its borrowing authority were increased. Senators Christopher Dodd and Mike Crapo introduced a bill that would permanently raise FDIC's borrowing authority to $100 billion, from $30 billion, and would also temporarily allow the FDIC to borrow as much as $500 billion in consultation with the president and other regulators.

This discussion confirms our starting assertion that deposit insurance premiums have either been risk insensitive or relied only on individual bank failure risk and never on systemic risk. Further, even when premiums have been risk sensitive, the focus has been on actuarially fair premiums. This is reflected in effectively returning the premiums to banks when the deposit insurance fund's reserves become sufficiently high relative to the size of insured deposits. This kind of premium scheme is poorly designed. It is highly pro-cylical in that the fund is never well-prepared for a reasonable systemic crisis and when one occurs it must raise the premium in the crisis rather than having done so in good times when banks would find it easier to pay. Further, the scheme is divorced from incentive properties. The rationale for charging banks a premium on a continual basis based on individual and systemic risk, regardless of deposit insurance fund's size, is that such a scheme causes banks to internalize in good times the expected costs imposed by the risk of their individual and joint failures on the deposit insurance fund and rest of the economy. Since a systemic crisis would most likely cause the fund to fall short and dip into taxpayer funds, the incentive-efficient use of excess fund reserves, if any, is as a return to taxpayers rather than to insured banks.

While the nature of our three prescriptions for the efficient design of premium schemes is straightforward, quantifying systemic risk can be a challenge in practice. However, it is time now for academics, practitioners, and policy-makers to rise up to this challenge. A recent advance in Acharya, Pedersen, Philippon, and Richardson (2009) proposes a measure of systemic risk – the average loss incurred by a bank when the system as a whole experiences outcomes in its “left tail” (the so-called Marginal Expected Shortfall or “MES” of the bank). Such a measure can be calculated based on historical data or projected based on bank characteristics and should be suitable for revisions to future deposit insurance schemes.

Viral V. Acharya is Professor of Finance at New York University Stern School of Business. Prior to joining NYU Stern, he was Professor of Finance and Academic Director of the Private Equity Institute at London Business School (LBS), a Research Affiliate of the Center for Economic Policy Research (CEPR) and an Academic Advisor to the Bank of England. His research interests are in the regulation of banks and financial institutions, corporate finance, credit risk and valuation of corporate debt, and asset pricing with a focus on the effects of liquidity risk.

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This article is largely based on Acharya and Yorulmazer (2009) "Systemic Risk and Deposit Insurance Premium," forthcoming, Economic Policy Review, Federal Reserve Bank of New York.

¹For example, Hoggarth, Reidhill, and Sinclair (2004) study resolution policies adopted in 33 banking crises around the world during 1977–2002. They document that when faced with individual bank failures, authorities have usually sought a private sector resolution where the losses have been passed onto existing shareholders, managers, and sometimes uninsured creditors, but not to taxpayers. However, government involvement has been an important feature of the resolution process during systemic crises: at early stages, liquidity support from central banks and blanket government guarantees have been granted, usually at a cost to the budget; bank liquidations have been very rare and creditors have rarely made losses.

²See Acharya (2009) for a fuller description.

³This discussion is largely based on Saunders and Cornett (2007), Pennacchi (2009), and Cooley (2009).

References

Acharya, Viral (2009) “A Theory of Systemic Risk and Design of Prudential Bank Regulation,” forthcoming, Journal of Financial Stability. Acharya, Viral, Lasse Pedersen,

Thomas Philippon, and Matthew Richardson (2009) “Regulating Systemic Risk,” Chapter 13 in Restoring Financial Stability: How to Repair a Failed System, eds. Viral Acharya and Matthew Richardson, John Wiley & Sons.

Acharya, Viral and Tanju Yorulmazer (2007) “Too-Many-To-Fail—An Analysis of Time-inconsistency in Bank Closure Policies,” Journal of Financial Intermediation, 16(1), 1-31.

Acharya, Viral and Tanju Yorulmazer (2008) “Cash-in-the-Market Pricing and Optimal Resolution of Bank Failures,” Review of Financial Studies, 21, 2705-2742.

Acharya, Viral V. and Tanju Yorulmazer (2009) “Systemic Risk and Deposit Insurance Premium,” forthcoming, Economic Policy Review, Federal Reserve Bank of New York.

Cooley, Thomas (2009) “A Captive FDIC,” available at http://www.forbes.com/2009/04/14/sheila-bair-banks-insurance-opinions-co....

Hoggarth, Glenn, Jack Reidhill, and Peter Sinclair (2004) “On the Resolution of Banking Crises: Theory and Evidence,” Working Paper #229, Bank of England.

Mailath, George and Loretta Mester (1994) “A Positive Analysis of Bank Closure,” Journal of Financial Intermediation, 3, 272-299.

Pennacchi, George (2009) “Deposit Insurance,” Paper prepared for AEI Conference on Private Markets and Public Insurance Programs.

Saunders, Anthony and Marcia Millon Cornett (2007) Financial Institutions Management: A Risk Management Approach, Irwin/McGraw-Hill.

Shleifer, Andrei, and Robert Vishny (1992) “Liquidation values and debt capacity: A market equilibrium approach,” Journal of Finance, 47: 1343-1366.