Transcript Financial Institutions

Class #16, Chap. 19
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
Milton Friedman on the Great Depression
3
Deposit Insurance
History
4
200
Number of Bank Failures
180
160
140
120
100
80
60
40
20
0
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
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
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)
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
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?
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
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

Premiums were paid by banks as a percent of deposits
held at the bank
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
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

State Depository Insurance existed
before then but it was insufficient
Depository Insurance Limit at Banks:
Year
1934
1935
1950
1966
1969
1974
1980
2008
Limit
2,500
5,000
10,000
15,000
20,000
40,000
100,000
250,000
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Does no bank failures mean
that the financial sector was
stable and healthy?
• Very few bank failures from 1940s-1980s.
• Depository insurance reduced the risk of
bank runs
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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
1970s-1980s reduced monitoring by
depositors along with deregulation
allowed banks to take on excessive risk.


Depository insurance is not uniquely responsible for the S&L crisis
Deregulation and fraud played a much larger role
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
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)
FDIC
Commercial Bank Fund:
Bank Insurance Fund (BIF)
Savings Association Fund:
Savings Association insurance Fund (SAIF)
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

2006 the FDIC merged the two funds BIF and SAIF into one fund to form
the Depository Insurance Fund (DIF)
As of 2009:
FDIC
DIF
6,995 Commercial banks with
4,054 Billion insured deposits
1,200 Savings institutions
759 Billion in insured deposits
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Problems with
Depository Insurance
Moral Hazard
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
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
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
Questions: Does depository insurance always lead to a
moral hazard problem?
No! only if it is mispriced

Depository institution profit
Increases with
bank risk
Π = Rrisky – Rdeposit – Rinsurance
Increases with
bank risk
Constant with
respect to bank risk
Constant with
respect to bank risk
If the insurance premium does not increase with bank risk,
the bank can increase profits by taking on more risk
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
Questions: Does depository insurance always lead to a
moral hazard problem?
No! only if it is mispriced

Depository institution profit
Constant with
respect to bank risk
Π = Rrisky – Rdeposit – Rinsurance
Increases with
bank risk
Constant with
respect to bank risk
Increases with
bank risk
If the insurance
risk, then
↑ $1premium increases with bank
↑ $1
banks cannot increase profits by taking on more risk. So,
there is no incentive to do so.
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Controlling DI Risk Taking
19
1.
Increase stockholder discipline
a)
b)
c)
2.
Increase depository discipline
1.
2.
3.
Insurance Premiums
Implementing risk based premiums
Increased capital requirements and stricter closure requirements
Insured Depositors
Uninsured Depositors
Regulatory discipline
1.
2.
Examinations
Capital Forbearance
20
Increase stockholder discipline
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
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:
Low Risk Banks
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
High Risk Banks
Insurance keeps
borrowing costs deposit
rates low for each group
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 risktaking behavior of high-risk banks
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
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.
2.
FDIC tables
Options Pricing
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Risk-Based Premiums
1. FDIC Tables
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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%
Uses the same capital adequacy measures
outlined in the Basel Accord
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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%
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?
$0.24
 0.0024 0.24%
$100
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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.
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Risk-Based Premiums
2. Options Pricing
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
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? FDIC has sold a Put Option
◦ What is the pre-specified price? Market value of assets = Insured deposits
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
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
P(T )  DerT  X 2   A X1 


ln(D / A)  r  s A2 / 2 T
X1 
sA T
 X 2  
X2
X 2  X1  s A T
D = value of insured deposits
A = value of bank assets
r = the risk free rate
s  volatility of returns on assets
T = Time to maturity – (term of insurance)
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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%.
P(T )  DerT  X 2   A X1 


ln( D / A)  r  s A2 / 2 T
X1 
sA T
X 2  X1  s A T
Step #1 Calculate X1 and X2
D = 60M
A = 75M
r = 0.04
s  0.17
T = 1 year


ln(60 / 75)  0.04  0.172 / 2 1
X1 
0.17 1
X1 
 0.22314  0.05445
 1.6329
0.17
X 2  X1  s T  1.6329 0.17 1  1.4629
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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%.
P(T )  DerT  X 2   A X1 


ln( D / A)  r  s A2 / 2 T
X1 
sA T
X 2  X1  s A T
Step #2 find Φ(X1) and Φ(X2)
 1.6329 
 1.4629 
-1.6329
-1.4629
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Find Φ(X1) = -1.63 on the table:
1.0000
- 0.9484
0.0516
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%.
P(T )  DerT  X 2   A X1 


ln( D / A)  r  s A2 / 2 T
X1 
sA T
X 2  X1  s A T
Step #2 find Φ(X1) and Φ(X2)
 1.6329 
 1.4629 
-1.6329
 1.6329  0.0516
 1.4629  ?
-1.4629
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Find Φ(X2) = -1.46 on the table:
1.0000
- 0.9279
0.0721
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%.
P(T )  DerT  X 2   A X1 


ln( D / A)  r  s A2 / 2 T
X1 
sA T
X 2  X1  s A T
Step #2 find Φ(X1) and Φ(X2)
 1.6329 
 1.4629 
-1.6329
 1.6329  0.0516
-1.4629
 1.4629  0.0721
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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%.
P(T )  DerT  X 2   A X1 


ln( D / A)  r  s A2 / 2 T
X1 
sA T
X 2  X1  s A T
Step #3 find insurance premium
P(T )  60Me0.04(1) (0.0721)  75M (0.0516)
P(T )  $4.136021M  $3.843351M  0.292671M
The FDIC should charge Clintonville an annual
premium of $292,671 for deposit insurance
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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
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Find Φ(X1) = -2.96 on the table:
Find Φ(X2) = -2.84 on the table:

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


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.
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Increase Depositor Discipline
43

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)
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Regulatory Discipline
45

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
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
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