Uninsured Deposits Research Articles

Depositor Liquidity and Loss-Sharing in Bank Failure Resolutions

Bank failures are widely feared for a number of reasons, including concern that depositors may suffer both losses in the value of their deposits (credit losses) and, possibly more importantly, restrictions in access to their deposits (liquidity losses). In the United States, this is not true for insured deposits, which are fully protected and made available to the depositor almost immediately. But both problems may occur for uninsured depositors. Thus, there is pressure on regulators to protect all depositors in bank failures. This is likely to increase both moral hazard risk-taking by banks and poor agency behavior by regulators with large ultimate costs to taxpayers. While ways of reducing the credit loss in bank failures have been widely examined, reducing liquidity losses has received far less attention. One way to mitigate this loss to uninsured depositors is to make the estimated recovery value of their deposits quickly available to them upon failure of the bank through an advance dividend or other payment by the FDIC secured by the bank's assets. Quick depositor access was suggested as a superior solution to deposit insurance in alleviating adverse effects from bank failures during the debate on deposit insurance in the early 1900s and was actually put into effect by both the Reconstruction Finance Corporation and the New York State Banking Department shortly before the establishment of the FDIC. More recently, the FDIC has experimented with the concept. This paper analyzes the pros and cons of providing quick depositor access to deposits at failed banks and reviews the history of the concept. It concludes that such a policy would greatly enhance the FDIC's ability to resolve large bank insolvencies without having to protect uninsured depositors through too-big-to-fail policies.

Too Big to Fail in U.S. Banking: Quo Vadis?

Too big to is one of the most frequently used but misunderstood terms in banking in the U.S. Except for a brief period in the mid-1980s after the insolvency of the large Continental Illinois National Bank caught the bank regulators unprepared and they did not fail the bank but kept it in operation and protected all depositors and other creditors of both the bank and its parent holding company, insolvent banks of all sizes were failed. But, all depositors were generally protected. Shareholders were wiped-out, as they eventually were even at the Continental. By 1990, TBTF had become an expensive and unpopular program and its potential use, even in its narrower form, was severally limited by the FDIC Improvement Act of 1991. The FDIC was explicitly prohibited from protecting uninsured depositors and other creditors in resolving insolvent banks if doing so would increase the cost of resolution to it. However, an exemption was provided in cases where protecting these claimants would avoid or mitigate potential serious adverse effects on the economy and financial stability. But invoking such a systemic risk exemption was made more difficult. Since 1992, no such exemption has been invoked by the regulators. However, no large money market bank has approached insolvency in this period, so that there has not been a real test. But any uncertainty is with regard to protection of some or all of the uninsured claimants, not with regard to legal failure. This paper traces the history of TBTF, analyzes the reasons for its use, and speculates on its use in future years.

A Proposal for Efficiently Resolving Out-of-the-Money Swap Positions at Large Insolvent Banks

Recent evidence suggests that bank regulators appear to be able to resolve insolvent large banks efficiently without either protecting uninsured deposits through invoking too-big-to-fail or causing serious harm to other banks or financial markets. But resolving swap positions at insolvent banks, particularly a bank's out-of-the-money positions, has received less attention. The FDIC can now either repudiate these contracts and treat the in-the-money counterparties as at-risk general creditors or transfer the contracts to a solvent bank. Both options have major drawbacks. Terminating contracts abruptly may result in large fire-sale losses and ignite defaults in other swap contracts. Transferring the contracts both is costly to the FDIC and protects the counterparties, who would otherwise be at-risk and monitor their banks. This paper proposes a third option that keeps the benefits of both options but eliminates the undesirable costs. It permits the contracts to be transferred, thus avoiding the potential for fire-sale losses and adverse spillover, but keeps the insolvent bank's in-the-money counterparties at-risk, thus maintaining discipline on banks by large and sophisticated creditors.

Dynamic Depositor Discipline in U.S. Banks

This paper investigates the presence of depositor discipline in the U.S. banking sector. We test whether depositors penalize (discipline) banks for poor performance by withdrawing their uninsured deposits. While focusing on the movements in uninsured deposits, we also account for the possibility that banks may be forced to pay a risk premium in the form of higher interest rates to induce depositors not to withdraw their uninsured deposits. Our results support the existence of depositor discipline: a weak bank may not necessarily be able to stop a deposit drain by raising its uninsured deposit interest rates.

Dynamic Depositor Discipline in U.S. Banks

This paper investigates the presence of depositor discipline in the U.S. banking sector. We test whether depositors penalize (discipline) banks for poor performance by withdrawing their uninsured deposits. While focusing on the movements in uninsured deposits, we also account for the possibility that banks may be forced to pay a risk premium in the form of higher interest rates to induce depositors not to withdraw their uninsured deposits. Our results support the existence of depositor discipline: a weak bank may not necessarily be able to stop a deposit drain by raising its uninsured deposit interest rates.

Depositor discipline and changing strategies for regulating thrift institutions

This paper examines the role of uninsured deposits as a source of thrift funding from 1984 to 1994, and tests whether uninsured depositors have adjusted their holdings at thrifts in response to market forces, such as indications of impending institutional failure. It also examines how the reactions have changed over time as new legislation has been implemented. The study finds that failed institutions exhibit declining proportions of uninsured deposits-to-total-deposits prior to failure and that failing institutions attract fewer deposits from uninsured depositors prior to failure than do solvent institutions. Though there are some differences between the periods, the empirical results indicate that uninsured deposits will be governed by market discipline and that reducing the insurance limits on deposits will increase market discipline on thrifts.

The New Safety Net

Following the costly banking and thrift crises of the 1980's and early '90s, the United States dramatically reformed the federal government safety net for depository institutions, which many blamed for the outbreak and high cost of the crises. The reforms, highlighted by the 1991 Federal Deposit Insurance Corporation Improvement Act, curtailed the public's liability for bank losses by increasing the portion that banks have to pay and the ability of the federal government tobail out uninsured depositors of large or politically well-connected banks and decreased abuse of Fedwire and Federal Reserve discount window lending. However, other reforms are still needed to improve the system further.

The Economic Performance of Small Banks, 1985-2000

Several trends in the financial industry over the past decade and a half have potentially threatened the competitiveness of small banks. Among these developments are the numerous mergers that increased the size and scope of large banks and the increased competition from mutual funds and other nonbank financial institutions. This article examines the economic performance of small banks during the 1985-2000 period by focusing on their ability to attract and profitably intermediate insured and uninsured deposits. It finds that the expansion of deposits and assets at small banks, when adjusted to account for the effects of mergers on measured growth, has consistently exceeded the growth at large banks. Moreover, the profitability of small banks has remained high over the period. These indications of strength among small banks as a whole also hold true for subgroups within the small bank sector. Aside from their success in attracting deposits, the key reasons for the generally good performance of small banks in recent years appear to be their ability to earn relatively high rates of return on their loans and an increase in the share of their portfolios devoted to loans.

FDICIA and bank failure contagion: Evidence from the two failures of first city bancorporation

We investigate contagion effects from the two failures of First City Bancorporation—the only large regional bank to fail before and after FDICIA. FDICIA imposes changes in the bank failure resolution process that expose uninsured depositors to substantially greater risk. We find that shocks to First City’s weekly returns affect the conditional volatility of all but the most financially sound banks in the 1985–1987 period. This risk spillover effect is not evident in the period leading up to First City’s 1992 failure, however, which suggests that the regulatory changes embodied in FDICIA have not contributed to a more risky banking system.

Business Strategies: Bank Commercial Lending vs. Finance Company Lending

Donald Simonson reviews the shift of a large share of the credit market to commercial financial companies during the last decade and asks whether the banks' loss of market share resulted in a loss of efficiency. In every year from 1983 to 1992 business credit at commercial banks. Reasons for this include the following: (1) Reduction in bank loans to businesses is a continuation of losses of business relationships. (2) Banks have lost the their historical funding cost advantage compared to nondepository intermediaries. (3) With the loss of banks' traditional blue chip corporate loan market, profitability concerns and the opportunity to exploit FDIC protection of their uninsured deposits attracted banks promise larger payoffs on high-risk loans to less-developed countries, energy development and production, real estate, and highly leveraged takeovers. This resulted in less lending to core customers in the small and middle markets. (4) Overzealous regulators and tough banks examinations may have been responsible for the cyclical decline in the availability of bank credit.

Market Discipline by Thrift Depositors

This paper tests for the presence of depositor discipline by examining the effect of depository institutions' risk on the pricing and growth of uninsured deposits. The study analyzes a large panel of thrifts that includes detailed information on interest rate schedules. This information allows the authors to develop a time-consistent risk profile for thrifts. Their empirical findings support the presence of market discipline. Riskier banks are found to pay higher interest rates but attract smaller amounts of uninsured deposits. The authors also find that qualitative results are similar for fully insured deposits, although statistical significance is substantially lower.

The New Depositor Preference Act: Time Inconsistency in Action

This paper presents issues arising from the enactment of legislation that changes the priority ordering of claims by uninsured depositors and the FDIC in the resolution of costly failed insured banks and thrifts. Under the legislation, uninsured domestic depositors and the FDIC receive preference in the payment of their claims in the resolutions of failed insured institutions over both foreign depositors and general creditors. As a result of the legislation, one can expect changes in the behavior of nonpreferred claimants.

Deposit Insurance, Capital Adequacy Requirements and Interest Rate Dynamics

This paper examines the long run interaction among deposit insurance, bank deposit rates and capital adequacy requirements. Using analysis similar to the price discrimination model of Lott and Roberts (1991) we find that a competitive environment among banks would link the spread between insured and uninsured deposit rates to the size of the insurance premium. We also find that banks that choose to operate at the regulatory minimum capital level, would increase asset risk with increased capital requirements if (1) the implicit interest paid to insured and uninsured depositors is equally sensitive to changes in risk and capital adequacy and (2) the insurance premium is independent of the level of risk and capital adequacy. Under the present risk‐based premium structure, asset risk has the potential to decline when the regulatory agency raises capital requirements. Finally, we examine the time series behavior of insured and uninsured interest rates to see if it is consistent with our theoretical model. We find that insured and uninsured rates, along with deposit insurance premiums, are cointegrated series as suggested by our model.

Households' Deposit Insurance Coverage: Evidence and Analysis of Potential Reforms

It is often suggested that reducing deposit insurance would reduce problems of moral hazard in the banking industry. However, little is known about likely effects of proposed reforms on household depositors. This study uses data from the Survey of Consumer Finances to examine the characteristics of household depositors, particularly those with uninsured funds. The authors find that large depositors tend to have substantial shares of their assets in insured depositories, yet often fail to keep their holdings within insurance limits. Various explanations for these factors are considered. The authors also simulate the effects of proposed reforms on the pool of uninsured depositors. Copyright 1996 by Ohio State University Press.

Response of uninsured depositors to impending S&L failures: Evidence of depositor discipline

This paper examines the behavior of uninsured deposits at savings and loan associations from 1986 to 1989 to discover whether depositors adjust their holdings of uninsured deposits in response to indications of impending institutional failure. The study finds that failing S&Ls exhibit declining levels of uninsured deposits and attract fewer uninsured deposits prior to failure than do non-failing S&Ls. Measures of financial strength and aggressiveness generally affect the level of uninsured deposits in the expected directions.

Panic in paradise: Florida's banking crash of 1926

Panic in Paradise is a comprehensive study of bank loan failures during the Florida land boom of the mid-1920s, during the years preceding the stock market crash of 1929. Florida and Georgia experienced a banking panic in 1926 when in a ten-day period in July, after uncontrollable depositor runs, 117 banks closed in the two states. Uninsured depositors lost millions, and several suicides followed the financial havoc. During the crisis in Florida bank assets fell more than $300 million in 1926 alone, and between 1926 and 1929, they declined from $943 million to $375 million. The banking debacle has been blamed on the collapse of the Florida land boom. It was believed that the precipitous drop in real estate values created a regional recession that caused the banks to fail. Bankers were not regarded as the problem. In fact, they were defended by bank regulators, who blamed the crisis on the public. Banks that operated prudently during this period survived the deceleration of the land boom. But many bankers looted the financial institutions they pledged to protect. They tried to get rich by wildly speculating with depositors' money. When their schemes failed, so did their banks. Using bank records that had been legally sealed for almost 70 years, Vickers demonstrates that despite official disclaimers and previous historical accounts, virtually every bank failure that occurred in Florida and Georgia during 1926 involved massive insider abuses, a conscious conspiracy to defraud, or both. Regulatory secrecy permitted the banking debacle to grow beyond control as regulators concealed the magnitude of the problem. If depositors had known what banking officials knew, the panic would not haveoccurred. Depositors did not know the true condition of the banks because insider abuses and fraud were hidden by regulatory secrecy. Bank examiners reported the self-dealings to senior regulators, who passively watched the looting and withheld the truth from the depositors. Even wh

Deposit Insurance and Regulatory Forbearance: Are Caps on Insured Deposits Optimal?

CONSIDERABLE ACADEMIC AND PUBLIC POLICY attention has been focused on the deposit insurance contract and, in particular, its mispriced deposit insurance premium. This has resulted in a burgeoning literature on the optimal pricing of deposit insurance guarantees [see Merton (1977, 1978), Pyle (1983), Ronn and Verma (1986), Acharya and Dreyfus (1989), and Allen and Saunders (1993) for examples]. In addition, other authors have studied the ability of uninsured depositors, or debtholders, to provide market discipline in the form of marketbased risk premia in the absence of explicit risk-based insurance premia [see, for example, Ellis and Flannery (1989) and Avery, Belton and Goldberg (1988)]. However, a third control instrument, namely the setting of ceilings or caps on the amount of deposit insurance coverage, has not been subject to rigorous investigation. In particular, while the FDIC (1989) and others have considered the general pros and cons of limiting the scope of deposit insurance, for instance, by lowering the $100,000 ceiling on the amount of insurance per account or by restricting the brokering in of deposits,l no formal analysis of the role of coverage caps can be

An empirical investigation of the existence of market discipline of off-balance sheet banking risk

Bank regulators are concerned with the dramatic increase and risk exposure of Off-Balance Sheet (OBS) banking activities in recent years, and request that some OBS activities be included in the calculation of a risk-based capital requirement. This paper investigates the riskiness of OBS activities. Specifically, this paper reports on three capital market tests of OBS banking risk: the impact of OBS activities on the risk premium of subordinated debt, on equity risk and on systematic risk of large commercial banks and bank holding companies. The underlying premise of this study is that the bank stockholders and subordinated debt holders are more exposed to the risk of bank failure resulting from OBS banking risk than insured and uninsured deposit holders. If the market notices the relationship between OBS activities and market measures of bank risk, and the market does something about it in terms of either higher prices or reductions in activities by banks that appear to be riskier, then market discipline of OBS activities is said to exist. The empirical literature, to date, has ignored the impact of OBS banking risk on the risk premium borne by subordinated debt holders. The results indicate that most OBS activities reduce risk premium and equity risk, but do not affect systematic risk. Both stockholders and subordinated debt holders price these OBS activities as risk-reducing. Therefore, regulatory interference in the form of additional capital requirement of OBS activities will penalize large commercial banks and will create distortions in the financial intermediation market.

A quality and risk-adjusted cost function for banks: Evidence on the ?too-big-to-fail? doctrine

We estimate a multiproduct cost function model incorporating measures of bank output quality and the probability of failure. We model a bank's uninsured deposit price as an endogenous variable depending on the bank's output level, output quality, financial capital level, and risk measures. Accounting for these aspects in the cost model significantly affects measures of scale and scope economies. We find evidence that the “too-big-to-fail” doctrine significantly affects the price a bank pays for its uninsured deposits. For large banks, an increase in size, holding default risk and asset quality constant, significantly lowers the uninsured deposit price.

Management and organizational changes in banking: a comparison of regulatory intervention with private creditor actions in nonbank firms

A key component of proposals for the mandatory closure of inadequately capitalized institutions is the requirement that management be replaced in any institution that fails to be recapitalized. The rationale for limiting regulatory discretion is that without rules, regulators will forbear. While regulators appear unwilling to impose losses on uninsured depositors, we present evidence that regulators act decisively in imposing penalties on managers of banks that perform poorly. We find that management-borne costs of poor performance are at least as great in banking as in other industries and that the costs of distress in banking increased during the 1980s.