1988 frb minneapolis

Federal R e se rve B ank

of M inneapolis

1988 A n nu al R eport

Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Contents

President’s Message

A Case for ReformingFederal Deposit Insurance 3

Statement of Condition 18

Earnings and Expenses 19

Directors 20

Officers 21

ACASEfo r R e fo r m m g

FEDERAL DEPOSIT

INSURANCE

Federal Reserve Bank

of Minneapolis

1988 Annual Report

By John H. Boyd

Research Officer

and Arthur J . Rolnick

Director of Research

The views expressed in this annual report are expressly those of the authors; they are not intended to represent a formal position of the Federal Reserve System.


President’s Message

h e p ro b le m s th a t in re c e n t y e a rs h a v e p la g u e d th e b a n k in g a n d th r if t in d u s tr ie s u n d e rsc o re th e n e e d to rev iew th e re g u la tio n s g o v e rn in g these

in s titu tio n s a n d th e in su ra n c e system p ro te c tin g d e posito rs . F e d e ra l d ep o sit in su ra n c e , in p a r t ic u la r , h as successfully p ro m o te d f in a n c ia l s ta b ility b u t , as w e see in th e c u r r e n t sav ings a n d lo a n crisis, th e costs o f d o in g so c a n b e v e ry h ig h . E sse n tia lly , as is th e case w ith in su ra n c e g en e ra lly , d ep o sit in su ra n c e e n c o u ra g e s ex cessive r isk ta k in g , th e so -c a lle d “ m o ra l h a z a r d ” p ro b le m .

In th is essay, w e a d v o c a te tw o re fo rm s w h ich , w e b e liev e , w ill a p p ly m u c h n e e d e d m a rk e t d isc ip lin e to b a n k s a n d o th e r d e p o s ito ry in s titu tio n s a n d , in so d o in g , w ill m it ig a te m o ra l h a z a rd . O n e p ro p o s a l— th e less c o n tro v e rs ia l o f th e tw o — is a n in c rea se in b a n k c a p ita l re q u ire m e n ts . A v ir tu e o f th is p ro p o sa l is th a t , if c a p ita l levels a re ra ise d , b a n k o w n ers w ill h a v e m o re a t stake a n d th e re fo re m ig h t c o n d u c t th e ir a ffa irs in a m o re p ru d e n t m a n n e r .

T h e seco n d , a n d m o re c o n tro v e rs ia l, p ro p o sa l is to rev ise fe d e ra l d ep o s it in su ra n c e to in c lu d e a c o - in su ra n c e fe a tu re . W h ile th e re a re a n y n u m b e r o f w ay s th is m ig h t b e a c c o m p lish e d , w e suggest th a t , a b o v e som e m in im u m , o n ly 90 p e rc e n t o f a d ep o s it be in su red . I f a d o p te d , su ch a sch em e sh o u ld s ig n ifican tly re d u c e th e cost o f p ro m o tin g f in a n c ia l s ta b ili ty b y e n h a n c in g m a rk e t d isc ip lin e . D e p o s ito rs w ill h a v e m o re in c e n tiv e to m o n ito r b a n k risk a n d to b e c o m p e n sa te d a c c o rd ing ly ; b a n k s , as a re su lt, w ill h a v e m o re in c e n tiv e to h o ld safe p o rtfo lio s . M o re o v e r , w e w o u ld e x p e c t coin su ra n c e to p ro m o te d iv e rs if ic a tio n a n d o th e r c h an g es in b e h a v io r t h a t w o u ld re d u c e system ic v u ln e ra b il i ty to a p ro b le m a t a p a r t ic u la r f in a n c ia l in s titu tio n .

In m y v iew , th is p ro p o sa l is fa r less r a d ic a l th a n it m a y seem a t first g lan ce . C o - in su ra n c e c a n b e p h a se d in g ra d u a lly a n d , as n o te d , sh o u ld p ro m o te a d ju s tm e n ts

T

t h a t l im i t th e s y s te m ic r e p e rc u s s io n s o f is o la te d p ro b lem s. N ev erth e less , w e ack n o w led g e th a t c o -in su ra n c e sacrifices som e o f th e s ta b ility ach iev ed w ith th e c u r r e n t d e p o s it in su ra n c e system , a sacrifice th a t seem s ju s tif ie d in v iew o f th e h ig h costs o f m o ra l h a z a rd . F in a lly , if in c re a se d m a rk e t d isc ip lin e is to be effective a n d e q u ita b le , d e p o s ito ry in s ti tu tio n s m u s t be tre a te d id e n tic a lly , irre sp ec tiv e o f size. T h e se p ro p o sa ls a re o ffered w ith th a t in m in d .

G ary H. S tern President

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F ederal deposit, insurance has long been regarded as one o( o u r most successful governm ent program s. It is now in need of serious repair. Established in 1933

to stem an instability problem in banking, deposit insurance succeeded as well as Congress could have hoped. M ore recently , how ever, as federally insured institu tions have becom e less regulated , a problem wit h deposit insurance has surfaced. In o rd e r to allow banks to survive in a m ore com petitive env ironm ent, Congress and bank regulators, over the past eight years, have relaxed the regulatory reins. But they did not, as some advised, reform deposit insurance. 1 As a result , banks have becom e m ore com pel it ive but at the expense of tak ing on considerably m ore risk. In elfcct. a fundam en ta lly difficult problem with deposit banking has been exchanged for one with deposit insurance.

O v er the years, m any econom ists have w arned of a problem with the federal deposit insurance system. W hile p ro tec ting depositors, deposit insurance encourages banks to take on m ore risk th an they otherw ise w ould. 1'his is the so-called ‘‘m oral h a z a rd ’* problem that is inherent w ith alm ost all insurance policies. How ever, because the deposit insurance system appeared to work so well and because so few banks failed, these w arnings went unheeded. P ro ponents of bank deregulation argued that the supervisory agencies were w ell-equipped to contain m oral hazard and that the low bank-failu re ra te provided strong support for this point ol view.

S om eth ing is now amiss. T h e low bank-failure ra te did not co n tinue into the 1980s. Since the beg inn ing of this decade over 800 banks have failed, including a few of the largest in the industry. M any m ore are lacing some financial difficulties. A m uch worse situation has developed in the savings and loan industry, which is p rotected by its own federal deposit insurance*. This industry has dem onstra ted just how high the cost o f m oral hazard can be. Estim ated losses to the* Federal Savings and Loan Insurance C o rp o ra tion T S L IC ; now range up to S100 billion or higher, a cost th a t will likely be borne by the taxpayer. No longer dot's it appear- that those who w arned of m oral hazard were crying wolf.2

T h ere is now an obv ious need to reform the way banks are regulated and depositors are protected. W hat is not so obvious is the best way to reform . Some suggest that banks be constra ined to holding only safe assets. O thers argue that closer m onito ring and pricing of bank risk will solve the problem . Still o thers believe troubled banks should be closed before their net w orth becomes negative. An exam ination of such reforms, however, suggests that they w on’t work and or are extrem ely costly.

T h e reform s, we th ink, that will be effective involve a la rger role for m arket involvem ent. And they reflect what we see in p rivate insurance con tracts that are successful in con ta in ing m oral hazard . In particu lar, private m arket experience suggests th a t the costs of contain ing m oral hazard will have to be shared by the insured. Depositors w ill hav e to bear some risk of loss— and bank owners a g reater share th an they do now. This, in tu rn , will mean the banking system will be potentially m ore prone to depositor instability. N evertheless, given the problem s with the current banking system, some tradeoff is war ranted.

Before federal deposit insurance was in place, the banking system was in periodic turm oil. Bank panics, a large num ber of bank failures caused at least in part by a general loss of confidence in the banking system and accom panied by a m ajor econom ic con trac tion , were a regular feature ol the I .S. econom y. Such panics occurred in virtually every decade following tin* passage o fth e N ational Banking Act of 1863. T he panic of 1907 finally convinced Congress that m ore direct governm ent involvem ent was necessary. W hile federal deposit insurance was discussed, it was u ltim ately rejected. In 1913 Congress created the Federal Reserve System to be the lender-of-last-resort: a central bank that com m ercial banks could tu rn to when depositors' confidence w aned. N evertheless, less than 20 years later, the U nited S tates experienced its worst banking panic as over one-fifth of I .S. com m ercial banks suspended operations ■ F riedm an and Schw artz 11963. p. 299 p.


To build depositor confidence and help p revent bank panics, Congress established the F ederal D eposit Insurance C orpora tion (FD IC). O n Ja n u a ry 1, 1934, the FD IC w ent into business insuring deposits up to $2,500 in banks th a t had chosen to becom e m em bers of this new governm ent corpora tion (on Ju ly 1 the m axim um coverage was raised to $5,000). O v er the years the fraction of to ta l deposits th a t the FD IC insured has gradually increased, as m ore depositors chose insured banks an d m axim um deposit coverage was raised. (See T ab le 1.) T oday , the F D IC insures deposits up to $100,000 per account, and this insurance covers over 75 percent of all bank deposits. But even so-called “ uninsured deposits,” those in accounts th a t exceed $100,000, have alm ost always been p ro tected as well. C onsider th a t of the 184 banks th a t failed in 1987 only 14 percen t of the u n insured deposits w ere no t pa id in fu ll.3 Because o f the FD IC , m ost depositors no longer have any reason to w ithd raw their funds based on fears and rum ors th a t th e ir bank is failing. Indeed, w idespread bank panics (of the sort experienced in the 1930s) have becom e in teresting curiosities in bank ing history, ra th e r th an con tem porary policy problem s.

One Problem Solved, Another IntroducedD eposit insurance solved an inheren t p roblem w ith deposit banking, bu t it in troduced an inheren t p roblem w ith in surance. M ost insurance has a po ten tia lly costly side effect called ‘ ‘m oral h a z a rd ,” w hich is well-know n in the industry. People who are insured against a p a r tic u la r risk have an incentive to change the ir behavior. C onsider the owners of a factory who purchase fire insurance. P rio r to this p u r chase, they w ould have to b ea r the en tire cost o f a conflagration. O nce insured, though, a great p a rt of the cost will be borne by the insurance com pany. F o r a fixed an n u a l fee the ow ners’ concern abou t such a loss is significantly alleviated , w hich is the obvious benefit of insurance. C onsequently , the insurance com pany should expect the insured to take m ore risks th an they w ould have w ithou t the in surance. T h e insured can now afford to be a little less cau tious ab o u t the disposing of flam m able m ateria ls such as old p a in t cans or chem ical containers. If the insurance com pany hopes to rem ain in business, it m ust take accoun t of such behavioral changes w hen p ric ing an d adm in istering policies.

T he federal deposit insurance system suffers from this sort o f problem . O th e r th ings equal, deposit insurance encourages banks to hold riskier portfolios th an they

Table 1Insured Deposits, 1934-1987

Year*

Maximum Dollar

Insurance Coverage

Per Account

Deposits in Insured Banks1

(in millions o f dollars)

Total Insured Deposits Deposits

Percentage of Insured Deposits

1934-39 5,000 48,662 21,815 44.81940-44 5,000 94,536 38,512 40.71945-49 5,000 153,994 73,789 47.91950-54 10,000 186,232 101,299 54.41955-59 10,000 229,432 128,854 56.21960-64 10,000 300,326 169,874 56.61965-69 15,000 442,915 262,955 59.41970-74 24,000 690,630 425,963 61.71975-79 40,000 1,048,224 691,832 66.01980 100,000 1,324,463 948,717 71.61981 100,000 1,409,322 988,898 70.21982 100,000 1,544,697 1,134,221 73.41983 100,000 1,690,576 1,268,332 75.01984 100,000 1,806,520 1,389,874 76.91985 100,000 1,974,512 1,503,393 76.11986 100,000 2,167,596 1,634,302 75.41987 100,000 2,201,549 1,658,802 75.3

deposits in foreign branches are omitted from totals because they are not insured. Insured deposits are estimated by applying to deposits at the regular Call dates the percentages as determined from the June Call Report submitted by insured banks.Source: Annual Report of Federal Deposits Insurance Corp. 1987.

*Data reported for the years 1934-1979 are annual averages.

otherw ise w ould. T h is follows im m ediately from the p ro tection provided by F D IC insurance: once insured, depositors have no reason to w orry abo u t the riskiness of th e ir b an k ’s activities. R egardless of how the b an k invests th e ir funds, insured depositors’ claim s are g uaran teed . D epositors, th e re fore, do not requ ire a risk p rem ium ; an d banks, therefore, have an incentive to invest in riskier projects. If these riskier projects are successful, the bank ow ners reap the h igher returns; if not, the governm ent insuring agency bears most o f the loss. D epositors’ funds ea rn the safe ra te o f re tu rn and are secure in e ither case.4


O ne m ight question w hether the m oral h azard p ro b lem is really th a t serious in bank ing because bank ow ners an d m anagers are no t p ro tec ted by deposit

in su rance— depositors are. Indeed , the owners can lose the ir equity if the b an k ’s loans go sour, and m anagers can lose th e ir jobs. Such losses, therefore, w ould seem to offset the effects o f m oral hazard .

T his view, a lthough intu itively appealing , misses the po in t. E q u ity is an in tegra l p a r t of the m oral h aza rd p ro b lem , an d the ow ners of the b an k are the ones w ho benefit from h av in g a h ig h -re tu rn /h ig h -r isk portfo lio . M o re over, some b an k ow ners are ab le to diversify m uch of this risk by hav ing only a sm all fraction of the ir to ta l resources invested in any one bank. C onsequently , owners could very well behave as if they were risk neutral; th a t is, they m ay sim ply seek to m axim ize expected re tu rn . If this is the case, we w ould expect such banks no t ju st to take on m ore risk th an otherw ise, b u t in fact to seek as m uch risk as possible.5

Moral Hazard Kept in Check by Protective S u b sid y. . .Policym akers were aw are of m oral h azard from the beginning. H istorically , the response to this prob lem has been heavy supervision an d regu la tion of bank ing activities. T his ap p ro ach m itigates the m oral h azard problem in two ways: first, by lim iting risky bank activities, and second, by p ro tecting banks from com petition.

D irect lim ita tions of risky activities have taken a variety of forms. F o r exam ple, bank risk is m onitored by th ree federal agencies and each s ta te ’s ch a rte rin g au thority . N a tiona l banks are exam ined regularly by the C om ptro ller of the C urrency ; s ta te -ch arte red banks are exam ined by the F D IC or the F edera l R eserve (if they are a m em ber), as well as the sta te in w hich they are charte red . All bank hold ing com panies are exam ined by the Federa l Reserve. Besides form al exam inations, banks have been restricted in the types of businesses they can own an d operate , in how m uch lend ing they can do w ith one person or one com pany, in w hat types o f loans they can m ake, and in how m uch of th e ir portfolio m ust be in liquid reserves.

R egu la to ry im pedim ents to bank com petition have included constrain ts on the n u m b er of bank charters, on w here banks could do business, on how m any b ranch offices banks could m ain ta in , and on the in terest rates banks could pay. In ad d itio n , n o nbank financial firms were proh ib ited from offering trad itio n a l bank products.

H ow successful has this strategy been in lim iting the effects o f m oral hazard? U n til recently, the record looked qu ite good, an d banks ap p eared as safe as the governm ent- insured deposits they offered. O ver the 40-year period 1940 to 1979, for exam ple, on average less th an seven banks failed p er year. (See T ab le 2.) In fact, th ere were so few failures th a t m any econom ists a rgued th a t the governm ent was over-regulating banks. T hey claim ed th a t banking, like o th er industries, needed to weed out its inefficient firms. W h at was lost in efficiency, though, was gained in safety. W ith relatively few exceptions, the U .S. banking industry appeared safe and sound.

T he m ost effective p a r t of this supervisory and regula tory strategy was to isolate the banking industry from com petition , allow ing it to earn h igh rates of re turn . Banks them selves were confined to well-specified geographic locations via in tersta te and in trasta te b ranch ing restrictions. A nd n o n b an k financial firms could not offer transaction accounts. In add ition , for m any years banks were p rohibited from pay ing interest on checkable deposits and lim ited in the ra tes they could pay on tim e an d savings accounts (R egulation Q). W ith few com petitors and few restrictions on the rates banks could charge on loans an d earn on investm ents, bank ing was a lucrative business even w ithout tak ing m uch risk. S hort-term , self-liquidating com m ercial loans an d w ell-collateralized, long-term loans, along w ith governm ent securities, were the stan d ard type of bank assets.6

T hese h igh rates of re tu rn , as reflected in the m arket value of a b ank charter, p resum ably provided the bank w ith a strong disincentive to take on too m uch risk. W hile the bank could have ea rn ed m ore by tak ing on m ore risk, the cost o f ban k ru p tcy was substantial; th a t is, the cost of losing a bank c h a rte r m ay have far outw eighed the gain from a risky portfolio strategy. T h e value of a b an k ’s charter, therefore, reflected the subsidy th a t was the quid pro quo for no t tak in g too m uch risk. T his p ro tective subsidy effectively reversed the risk -re tu rn tradeoff facing the banker. T he subsidy was h igh enough so th a t incu rring m ore risk w ould low er— not raise— the b an k er’s expected return.

T he protective subsidy was the cost of successfully con ta in ing m oral h azard in banking. This cost was m an ifested by the lack of com petition in bank services. W hat has been labeled 3 /6 /3 bank ing characterized the industry for decades— borrow a t 3 percent, lend a t 6 percent, and be on the golf course by 3 p .m .— a good life th a t p resum ably few


were w illing to risk losing, despite the incentives c rea ted by deposit insu rance.7

— But the Protective Subsidy Has Been Eroded by CompetitionSince 1980 the pro tective subsidy appears to have lost its effectiveness. O ver 800 banks have failed, 522 in the last th ree years. A nd a significant p a r t of the savings an d loan industry, first-cousin to banking, is facing bankrup tcy . (A ccording to unpublished F ederal H om e L oan Bank reports, on Ju n e 30, 1988, 16 percen t o f all savings an d loans were b an k ru p t on an ad justed regulatory cap ita l basis.)

T ab le 2 c learly illu stra tes the p ro b lem th a t beset the bank ing industry in the ’80s. As no ted earlier, from 1940-79, this coun try averaged less th a n seven b ank failures p er year. By contrast, from 1980-88, an average of abou t 92 banks failed p er year. T h e d a ta also suggest th a t m ost failures p rio r to 1980 involved relatively sm all banks. B eginning in 1980 th a t was no longer true , and in fact a few of the largest banks w ere getting in trouble . F or exam ple, from 1945-54, to ta l assets o f closed banks av eraged abou t $5.8 m illion annually . F rom 1980-87, to ta l assets of closed banks averaged ab o u t S6.2 billion annually . T he figures for deposits of closed banks tell the same story. O f course, p a r t o f the increase in failed bank assets and liabilities simply reflects the effects o f inflation. But, some of the largest p roblem banks in the 1980s w ere reorganized w ith governm ent assistance, an d thus are no t included in the T ab le 2 data .

W h a t w en t wrong? W hy h ad a previously well- m anaged problem becom e difficult to control?W h at h ad hap p en ed to the p ro tective subsidy?

These are com plex questions th a t we m ay no t be able to answ er satisfactorily for m any years. N evertheless, a t least p a rt of the exp lanation is c lear now. T h e double-d ig it inflation experienced in the 1970s opened the door to nonbank com petition an d w ith in a few years eroded the value of bank charters.

C om petition from no n b an k financial firms cam e qu ick ly on the heels o f inflation. W ith h igher ra tes of inflation cam e h igher rates of interest. O nce m arke t rates exceeded the m axim um rates banks could offer th e ir depositors, a host of nonbank com petitors em erged. T h rift institu tions w ere am ong the first to challenge the com m ercial banks’ m onopoly on transac tion accounts. U n til the m id-1970s it was easy

for the pub lic to differentiate banks from thrifts. Banks offered checking accounts an d savings accounts; the thrifts offered only savings accounts. In 1972, how ever, two New E ngland states p erm itted th e ir m u tu a l savings banks to offer a checking deposit th a t becam e know n as the N O W account (N egotiable O rd e r of W ithdraw al). Several im po rtan t court decisions supported the view th a t banks could not be g ran ted a m onopoly on the issue of th ree -p a rty negotiable instrum ents payable upon dem and (i.e., checks). W hile there were initially lim itations on w ithdraw als, these N O W accounts, unlike dem and deposits a t banks, pa id interest. N ot surprisingly, they were an overnight success, as is clearly shown in T ab le 3. Between 1976 and 1981 N O W accounts

Table 2Number, Deposits and Assets of Insured Banks Closed Because of Financial Difficulties, 1934-1988

(in millions o f dollars)

Banks T otal TotalYear* Closed Deposits Assets

1934-39 52.5 49 571940-44 17.0 41 471945-49 3.0 6 61950-54 3.0 12 61955-59 3.2 9 81960-64 3.2 13 171965-69 5.6 44 521970-74 4.8 551 1,0831975-79 10.4 475 5641980 10 216 2361981 10 3,826 4.8591982 42 9,908 11,6321983 48 5,442 7,0271984 79 2,883 3,2761985 120 8,059 8,7411986 138 6,471 6,9921987 184 6,282 6,8511988 200 n.a. n.a.

Source: Federal Deposit Insurance Corporation.*Data reported for the years 1934-1979 are annual averages.


grew from S2.7 billion to $78.5 billion. O ver the sam e period dem and deposits a t banks increased only abou t 5 percent.

A bout the same tim e, the large brokerage houses saw o pportun ities in this a rea an d began to offer m oney m arket m u tu a l funds. In the la te 1970s they ad d ed checkw riting privileges. T ypically , these m oney m arke t accounts carried a h igher ra te of in terest th a n N O W accounts b u t h ad m ore restrictions on w ithdraw als. T ab le 3 illustrates the success of these funds, w hich grew from S3.4 billion in 1976 to over S I88 billion by 1981.

N ew com petition h it ban k in g from the asset side of the business as well as the liab ility side. In the 1970s, foreign com m ercial banks began cap tu rin g a grow ing share of the U .S. com m ercial loan business. M any large corporations ab an d o n ed banks for th e ir borrow ing needs by going d irectly to the com m ercial p ap e r m arket. A nd nonfinancial firms such as the au to m anufac tu rers and large retailers began a concerted effort to expand the ir share of the consum er loan m arkets.

T h is increased com petition d id no t go u nno ticed by the

Table 3Bank Demand Deposits and Substitute Instruments 1976-1987 (in millions o f dollars)

Y earDemand Deposits

a t BanksN O W

AccountsM oney M arket M utual Funds

1976 231,300 2,700 3,4001977 247,000 5,000 3,8001978 261,500 8,400 10,2001979 270,100 17,000 42,9001980 274,700 27,400 76,6001981 243,400 78,500 188,6001982 246,200 104,100 236,3001983 251,000 132,200 181,4001984 253,000 148,200 230,2001985 276,900 180,900 241,0001986 314,400 237,300 292,4001987 298,500 261,600 310,700

Source: Federal Reserve Bulletin, various dates.

policym akers. T o allow banks to com pete on a m ore equal basis, Congress passed the D epository Institutions D eregulation and M onetary C ontro l A ct of 1980 (D ID M CA ), which called for the m ost rad ical changes in banking regulation since the 1930s. T h e ac t con ta ined several m ajor provisions designed to allow banks to com pete m ore effectively w ith th e ir n o n b an k com petitors. In terest ra te ceilings on bank deposits were to be phased ou t over the next several years, an d federal reserve requ irem ents were lowered across the board an d im posed on all institu tions offering insured transaction accounts. (To allow the savings and loan industry to com pete, Congress passed the G arn-S t G erm ain D epository A ct of 1982 w hich allow ed a savings and loan to m ake com m ercial loans as well as hom e m ortgages.)

In add itio n to D ID M C A , regulators expanded allow able bank activities. M an y states perm itted the ir state- ch a rte red banks to ow n subsidiaries in o ther lines of business. T h e F ederal Reserve also was m ore lenient w ith bank hold ing com pany activities, and an increasing num ber of securities activities w ere p e rm itted .8

A ll this com petition has had the expected effect on the m arke t value of bank charters. Explicit charte r values are no t availab le , b u t they can be estim ated.

Since c h a rte r values are included in the m arket value of b ank equities an d not inc luded in the book value (under s tan d ard accoun ting procedures), the ratio of m arket to book reflects to some ex ten t the value of a bank charter. As show n in F igu re 1, an d as expected , the m arket value of bank equities exceeded the book value from the early 1950s u n til the early 1970s w hen the ra tio began to decline. By the m id-1970s, m ark e t value ac tually fell below book value, w here it rem ains today. O f course, ch a rte r values can never fall below zero and , therefore, there m ust be some o ther reasons w hy b an k equities have been selling a t such low prices. M ost p robab ly , this is due to an oversta tem ent of some book assets due to un realized loan losses. Nevertheless, several recent studies have docum ented the decline in bank ch a rte r values, an d one has presented evidence th a t banks w ith below -average c h a rte r values have above-average willingness to take risk (K eeley [1988]).

In sum m ary , as b ank ing becam e less p ro tected from com petition an d less regulated , the incentive to take on risk increased. M o ra l h azard , long la ten t, started to be a force an d the results w ere as expected: banks began reach ing for profits by reach ing for risk. Even though banks con tinued to


Figure 1Ratio of Market Value of Equity to Book Value of Equity, 1952-1987

The 25 largest bank holding companies.Data provided by Federal Reserve Bank of San Francisco.

be m onitored and supervised by a p le th o ra of governm ent agencies, such regulation proved ineffective in the face of increased com petition an d the loss of the pro tective subsidy.

W ith inflation, com petition , deregu la tion an d the resulting decline in the protective subsidy, m oral h aza rd has em erged as a serious concern. A ddressing this problem is neither going to be easy no r inexpensive. T h e ap p ro ach w hich appears the m ost logical, reim posing the regu la to ry structu re th a t p roduced the halcyon years before deregulation , is not realistic. O nce the doors to com petition are opened, closing them is extrem ely difficult. It w ould requ ire a severe re trenchm ent of the en tire financial industry.

A realistic solution requires some recognition of the tradeoff betw een the two in h eren t problem s: the instability in deposit bank ing versus the m oral haza rd in deposit insurance. T his tradeoff can n o t be ignored. A voiding m oral hazard is difficult if deposits are insured, and avoiding depositor instab ility is difficult if th ey ’re not. Because of this tradeoff, there are no perfect o r easy answers to e ither problem . T h e first-best solution is sim ply un a tta in ab le .

Policy proposals w hich claim to have first-best solutions are sim ply m isguided. N evertheless, there is a m uch better answ er th an ou r cu rren t regulatory fram ew ork.

T o b e tte r un d erstan d the choices facing policym akers, consider the two po lar options: full-coverage insurance (w here all deposits are fully pro tected), o r none a t all. T he form er elim inates instability , b u t results in m oral h aza rd in the extrem e. T he policies we have in place today are closest to this option. T he la tte r option elim inates m oral hazard , b u t results in depositor instab ility in the extrem e. T his was the policy before 1934, b u t as noted , the bank ing system was subject to periodic panics.

H av ing seen the results o f these p o la r options, we th ink ne ith e r is correct. R a th e r, the best policy solution lies som ew here betw een these alternatives. Before presenting o u r concept of w hat such a m ore m o d era te system m ight en tail, how ever, we first discuss some recent reform p ro posals th a t we view to be ineffective, extrem ely costly or bo th .-T hese include 100 percen t reserve banking, closing banks before they fail, an d risk-adjusting cap ita l o r insurance prem ium s. T hen , we tu rn to proposals th a t we th ink are better.


100 Percent Reserve BankingO ne proposal th a t has been around a t least as long as deposit insurance is 100 percen t reserve banking. K now n today as the n arrow bank ing concept, it takes the regu la tion of b ank ing to its very lim it.9 U n d e r n arrow banking , banks could only invest in safe, liqu id assets. (H old ing 100 p ercen t cash reserves w ould obviously satisfy this requ irem ent.) T he n arrow ban k in g concept w ould also allow banks to hold short-term T reasu ry deb t as well as non in terest-bearing reserves. O n the surface, this proposal appears to solve both the m oral h aza rd prob lem an d the depositor instability p rob lem a t once. M o ra l haza rd is sim ply regu la ted aw ay because banks canno t invest in risky assets. Instab ility is overcom e because deposits are 100 percen t backed by safe assets— there is no reason for depositors to lose confidence or to ever fear a bank failure.

A ppearances are deceptive. W hile the n arrow banks w ould be safe, w hat w ould h ap p en to all the in te rm ed ia tion (th a t is, m a tch in g of borrow ers an d lenders) th a t they did previously as “ wide banks” ? In te rm ed ia tion services w ould still be dem anded , and presum ably o th er financial in stitu tions w ould fill the g ap —opera ting m uch like the old wide banks. As such, the new institu tions w ould be p rone to depositor instab ility if they w ere no t insured an d m oral h aza rd if they were. T h e problem , in o th er words, w ould not be solved b u t only shifted to a different p a r t of the financial sector. A nd if the regulators w ere able to p reven t this shifting, m ost of the bo rrow ing an d lending th a t was h istorically perform ed by banks w ould be e lim inated , a cost th a t w ould surely exceed the benefits of narrow banking.

Closing Banks Before They FailA nother proposal th a t looks like it w ould solve b o th m oral h aza rd an d instability w ith very little cost is to close troub led banks before they go b an k ru p t (Shadow F inancial R eg u la to ry C om m ittee, 1988). T h e idea here is th a t if banks a re closed w hen th e ir net w orth is close to zero, the in su re r’s exposure (the ad m in istra tive costs o f closing the b an k and selling its assets) is relatively small. Presum ably , if banks know they will be closed th a t quickly, they will also be less prone to take risks. T he m oral h aza rd problem then is solved (since the F D IC never takes losses) an d depositors’ funds are always safe.10

Like the n arrow b an k in g proposal, the costs o f such an a rran g em en t are m uch g rea te r th a n they m igh t ap p ear. I t ’s one th in g to say tro u b led banks should be closed before they

are b an k ru p t, b u t an o th e r to p u t this principle into p rac tice— th a t is, to de term ine precisely w hen any p a rtic u la r bank should be closed. R egulators currently m onitor the n et w orth of banks; th ro u g h call reports and form al bank exam inations they determ ine the net w orth of banks a t least four tim es a year, an expensive process. A nd even these da ta are subject to errors. E v a lu a tin g the value of assets th a t are not trad ed in a secondary m arket (such as most com m ercial loans) is open to considerable un certa in ty and sometimes q u ite a rb itra ry . U n d e r the proposal to close banks quickly, one w ould have to m onito r banks m ore frequently and m ore accu ra te ly th a n we now do, an d the costs could well be prohibitive.

F urth e r, the in form ation p roblem is m ore com plex th an identify ing low -quality loans. By the very n a tu re of banking, m any loans are w orth relatively

little if sold on the m arket today , bu t are in fact good loans w ith h igh fu tu re payouts. O n ly if regulators were able to g a th e r the sam e q uality of in form ation the banks have could they m ake the d istinction betw een short-run and long-run values. T his w ould not only be expensive, b u t inefficient as well because it w ould en ta il a rep lication of inform ation costs th a t banks have already in cu rred .11

Risk-Adjusted Insurance Premiums or Risk-Adjusted Capital RequirementsR isk-ad justed insurance prem ium s or risk-adjusted cap ita l requ irem en ts are proposals th a t also ap p ea r to solve the m oral h aza rd prob lem w hile keeping deposits safe. In add ition , these proposals a p p e a r to be m arket-orien ted , for p resum ably p riva te insurers w ould charge th e ir riskier custom ers a h igher prem ium or require larger deductibles. O n closer exam ination , how ever, the costs of effectively adm in istering such policies w ould likely be prohibitive, even for p riva te insurers.

T o adm in iste r a risk-adjusted insurance policy requires some w ay of accura tely assessing risk. A nd again , there is the cost of some very expensive inform ation. W h at do private insurance com panies do in this situation? In practice , in surance com panies generally engage in lim ited m onitoring o f risk behavior. Physical exam inations, drivers’ tests and p ro p erty inspections are typically requ ired before the in surance is g ran ted , b u t rarely will the insurer continually m o n ito r the h ea lth of a p a tie n t o r the cond ition of a factory. G iven the cost o f m onito ring , it is likely th a t p riva te insurers


of banks would not operate much differently. Regular monitoring of banks’ behavior toward risk is labor-intensive and expensive. And even if the risk could be measured accurately, pricing this risk without market data on the value of bank loans would be difficult and arbitrary.

That is not to say some broad-risk categories could not be established and priced (as age is used, for example, with health and auto insurance). Indeed, the new capital standards established under the Basle Agreements of 1988 feature this sort of rough-and-ready risk categorization.12 While the new capital standards are surely an improvement over the old, there are still continuing problems. For one thing, by definition, they favor bank investment in some asset categories over others. There is always the danger that these standards may become politicized (here, or in other countries), which could result in a significant misallocation of resources. Moreover, the new capital standards invite loophole exploitation on the part of banks, which have a natural incentive to find (or create) assets which have had their true risk underestimated. In fact, this process is already beginning, and the effectiveness of the capital standards will depend substantially on the authorities’ zeal in finding and plugging loopholes. This approach will not help much with the moral hazard problem. Too many arbitrary decisions have to be made, and too many loopholes have to be closed.

Need to Rely More on Private Market InvolvementWe have questioned those proposals that don’t face up to the tradeoff between moral hazard and depositor instability. Each of the above proposals attempts to reduce moral hazard without affecting the safety of bank deposits. That is not possible, at least not at any reasonable cost. These proposals either require exorbitant information costs or don’t, in fact, avoid the tradeoff. An effective solution must recognize that there is a tradeoff. The current state of the system is near one extreme; it minimizes the possibility of bank runs at the expense of maximum moral hazard. Since there appears to be no panacea, the tradeoff necessarily means accepting somewhat more depositor instability than is now the case.

The problem, then, is to reform deposit insurance so that there is a better balance between moral hazard and depositor instability. Because the private market tends to allocate resources efficiently, the way to do this is to redesign deposit insurance so that it incorporates features found in most private insurance contracts—higher deductibles and

some degree of co-insurance. This in turn will mean more market discipline of banks and private bearing of risk.

Increasing the DeductibleThe deductible is one way most insurance contracts are designed to limit the insurance company’s loss. Required bank capital, at least from the FDIG’s point of view, is the deductible in deposit insurance—the higher the capital, the lower the FDIC’s exposure.

Raising capital requirements would also help to reduce moral hazard. It would do this in two ways, and the first is fairly obvious. To the extent that bank owners are risk- averse and cannot completely diversify their investments, more capital helps to offset the incentive to risk-taking because owners have more at stake. The second effect is less direct and considerably more subtle. Other things equal, a higher capital requirement will reduce the expected losses of the FDIG, effectively reducing the net subsidy to banking due to deposit insurance. Reducing this subsidy will cause some shrinkage of the banking industry—either as banks cut back on marginally profitable lending or as marginally profitable banks are driven out of business. To the extent the industry is made smaller as the insurance subsidy is reduced, so is the moral-hazard problem.

Furthermore, raising capital requirements will bring capital-asset ratios closer to their pre-deposit insurance levels, levels that presumably reflect a more prudent amount of bank capital. Consider the historical bank capital ratios shown in Figure 2. Before 1933, banks held much more capital than they now do. In fact, from 1844 to 1900, average capital ratios exceeded 20 percent of assets. In recent years, the average has been around 6 percent. Figure 3 shows contemporary capital ratios for banks (actually consolidated bank holding companies) in comparison with other financial intermediary firms in different industries. The other industries are generally less regulated than banking and none have deposit insurance. The capital ratios of the nonbank firms are in all cases much higher than in banking. Both data comparisons suggest that were it not for deposit insurance, banks would most likely hold much more capital.

Establishing Co-InsuranceIn searching for other ways to mimic a private-market solution to moral hazard, we found an answer in co- insurance.13 This technique is often used by private insur-


Figure 2Commercial Banking Industry Capital/Assets Ratio: 1834-1986

Notes: Series (1) and (2) are from Historical Statistics o f the United States Colonial Times to 1970. U.S. Dept, of Commerce, USGPO, 1975 which provides a detailed discussion of these data. Series (3) is obtained from the Federal Reserve Bulletin, and FD IC Annual Statistics, various dates. The definition of the capital account has changed somewhat over time, and it is not possible to construct an absolutely consistent series from 1834 to the present. Generally, however, the capital account includes capital, surplus, net undivided profits, reserves for contingencies, and certain other reserve accounts.

Figure 3Median Ratio of Equity to Assets, 1971-1984 Bank Holding Companies and Other Financial Firms

BHC Securities Life Property/ InsuranceInsurance Casualty Agents

Insurance

Note: Average ratios are computed for each firm: Medians are reported for each industry. Source: Boyd and Graham (1988, p. 12)


ance com panies to con tro l m oral hazard . It makes the insured b ea r some of the cost of a bad outcom e and encourages safe behavior. In banking, this will m ean some loss of depositor confidence, since only a percentage of deposits w ould be insured. T h e tradeoff, as we have noted, how ever, is unavo idab le . A t least w ith co-insurance the trad eo ff w ould be m ade explicit and the ability to m anage the tradeoff should be enhanced .

In m any p riv a te insurance arrangem ents there is at least some risk-sharing, w hich can take a variety of forms, bu t the m ost typ ical is co-insurance. W ith m edical insurance, for exam ple, the insured (after some deductible) m ay be covered for only 90 p ercen t o f expenses. T he incentives c rea ted by such co-insurance are obvious. T he insured are m ore likely to consider the costs of m edical problem s. Ju st as im p o rtan t, the incentives encourage the insured to consider h ea lth p rogram s th a t reduce the need for m edical care in the first place.

o-insurance in b an k in g w ouldn’t work exactly as itI does in the h ea lth industry , bu t the incentive effects

w ould be sim ilar. If deposits were insured only up to 90 percen t, for exam ple, all depositors w ould have an in terest in the financia l h ea lth of the ir bank. T o be com petitive w ith banks th a t hold relatively safe portfolios, banks th a t chose risk ier portfolios w ould have to offer th e ir depositors a h ig h er ra te of re tu rn . C onsequently, because risk w ould now be priced, banks w ould have less incentive to choose such portfolios an d the m oral h azard problem w ould be reduced.

C o-insu rance could also be designed to to tally protect sm all savers. F o r exam ple, the first S I0,000 of savings could be 100 p ercen t insured. T o avoid the brokering of deposits, th is 100 pe rcen t insurance lim it w ould apply to the in d iv iduals, no t to accounts. A n ind iv idual w ould be able to identify only one accoun t anyw here th a t w ould have this coverage, an d a n y th in g over this lim it (and all funds in o ther accounts) w ould be subject to co-insurance.

Som e m ig h t arg u e th a t if we simply enforced the insurance system we have in p lace today, w ith its $100,000 ceiling, we cou ld ach ieve the sam e result. O f the billions of dollars in deposits, ab o u t 23 percen t are large, uninsured deposits. In prac tice , how ever, regulators have been extrem ely re lu c tan t to let these relatively few large depositors b ea r the b ru n t o f a bank fa ilu re—especially w hen m any of them are, them selves, com m ercial banks.

T w o m ajo r advantages exist in adop ting co-insurance over sim ply p u ttin g teeth in the present $100,000 limit. F irst, it is a very different situation w hen all depositors suffer sm all losses th a n it is w hen a few depositors suffer large losses. T h e likelihood of failures tran sm itted from one bank to a n o th e r is g reatly reduced. A nd second, m odifying the form al stru c tu re o f the deposit in su rance system w ould send a strong message to the m arketp lace (and, for th a t m atte r, to regulators) th a t a real change was tak ing place. Ju s t an n o u n cin g a “ get to u g h ” policy u n d e r the present insu rance system is a strategy th a t has been tried , w ith very lim ited success.

Tim e Inconsistency: A Policym aker’s DilemmaT he lim ited success of the get tough policy is sym ptom atic of a m ore general p roblem . If co-insurance is to m itiga te m oral h aza rd , policym akers m ust confron t w hat is know n as the “ tim e inconsistency” dilem m a: A policy th a t is best for the long ru n m ay no t be best for the short run , an d v ice-versa .14 C onsider the d ilem m a as it arises w ith deposit insurance. O nce a bank is on the verge of failing, it often ap p ears th a t the best policy is to p ro tec t all depositors, bo th insured and uninsured . T he F D IC can p ro tec t all depositors by a rra n g ing the purchase and assum ption of a troub led bank by a h ea lthy one. F or decades this ap p ro ach was often used because it m inim ized the F D IC ’s cost of han d lin g a failing bank. T his was the low-cost m ethod , a t least partly because in a purchase an d assum ption transaction the ch a rte r value is c ap tu red by the FD IC . T his ap p ro ach (or publicly announcing th a t all depositors will be pro tected) has the ad d itio n a l ad v an tag e th a t ac tu a l o r po ten tia l bank runs are ha lted , allow ing the reo rgan ization to proceed in an orderly m anner.

W hile such policies m ay indeed m inim ize the cost of any p a r tic u la r bank closure, they do not necessarily represen t the best long-run policy. T h a t’s because the un insured depositors will lea rn over tim e th a t, w hatever is the announced policy, th e ir deposits are actually safe. W hen th a t happens, “ un insured depositors” no longer care abou t bank risk an d m arke t discipline is lost. C onsequently , there are m ore bank failures th a n th e re w ould have been, h ad un insured depositors not been protected .

T im e inconsistency is also a p rob lem in the trea tm en t of large, troub led banks. T he c u rren t announced policy is th a t all bank failures are h an d led u n d e r the sam e set of regulations an d general principles. But the announced


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policy is clearly tim e-inconsistent, because regulators fear the financial havoc th a t could result if a large bank were allow ed to fail. Q u ite p red ic tab ly , the announced policy has no t been followed; an d ju s t as p red ic tab ly , it is now widely perceived th a t all depositors in large banks are fully p ro tec ted u n d e r v irtua lly all circum stances. This m arket percep tion confers a significant (albeit un in tended) com petitive advan tage on the largest banks.

F or p resen t purposes, the point is obvious. If co- insu rance is to be m ade effective, it m ust be tim e-consistent. T h a t is, the au th o rities m ust not p ro tect the uninsured po rtio n of depositors’ accounts, w hether they’re in small banks or large ones. W ith a system of higher cap ita l ratios an d co-insurance, how ever, F D IC losses w ould be fewer th an w ith the cu rren t system. Thus, the short-run cost ad v an tag e of purchase an d assum ption transactions would be reduced . As far as failing large banks are concerned, losses w ould be spread across a w ide spectrum of depositors, an d no t c o n cen tra ted in a relatively few large, uninsured ones. O f course, any deposito r’s m axim um loss would be bo u n d ed by the co-insurance percentage lim it. Thus, the likelihood o f ca tastro p h ic losses for a few depositors would be greatly reduced.

P erh ap s m ore im p o rtan t, m arket discipline would w ork b o th before an d after the fact. By this we m ean th a t d epositors w ould be m ore careful, paying some a tten tion to the financial condition of th e ir banks in good times as well as bad . In net, th is w ould ten d to concen tra te deposits in w ell-run, low er-risk institu tions, unlike the present system. S m aller banks w ould be m ore careful about leaving b a lances of several tim es th e ir cap ita l in correspondents, and so on. F o r all these reasons, the dangers of perm itting a large bank failure w ould be grea tly reduced.

W e have a rg u ed th a t deposit insurance should be reform ed to b e tte r reflect p riv a te insurance principles and to en courage m arke t discipline. T his implies m ore d irect m arket involvem ent in b ea rin g b an k risk. T h rough higher d ed u c tibles (capital requ irem ents) an d co-insurance, shareholders an d depositors will have an increased stake in the soundness o f th e ir banks.

T his proposal has the significant advantage of gradual im p lem en ta tio n w ith m odification to the present system. As Professor R o b e rt Lucas, U niversity of Chicago, once observed,

. . . a tte m p tin g various policies th a t m ay be proposed on ac tu a l econom ies an d w a tch ing the ou tcom e m ust not be tak en as a serious solution m ethod: Social experim ents on the g ran d scale m ay be instructive an d ad m irab le , b u t they are best adm ired a t a distance. (Lucas, [1983, p. 288].)

O u r proposed changes can be im plem ented on a sm all scale an d carefully, thus avoiding the obvious risks of massive regu lato ry upheaval. C ap ita l requ irem ents can be raised g rad u a lly an d w ith advance w arn in g to the industry . Sim ilarly , co-insurance can be phased in as deem ed a p p ro pria te . F or exam ple, we could ad o p t a system of 100 p ercen t deposit insurance up to S I0,000 and co-insurance for any g rea te r deposit balances, say 2 p ercen t the first year and increasing by a p ercen t o r so each year after th a t. T h e po in t is, the in itia l co-insurance b u rd en of depositors w ould be sm all (raising th e ir risk consciousness a bit) b u t hard ly reducing the ir insurance coverage. A n im p o rtan t and difficult question is: H ow large should the fractional co- insurance b u rd en of depositors u ltim ate ly becom e? W e do no t p re ten d to know the answ er, and it will surely requ ire an analysis beyond the scope of this essay.

Who Would Gain and Who Would LoseT his proposal, even if fully successful in con ta in ing m oral h aza rd an d correc ting a p o ten tia lly costly problem , will not necessarily benefit everyone. Some will benefit m ore th an o thers, an d some will be worse off th an they are u n d er the c u rren t system. W ho w ould gain and who w ould lose? Those m ade b e tte r off w ould include the F D IC , the taxpayers and some com m ercial banks. T h e FD IC w ould be an obvious w inner, since its insurance liabilities w ould be directly reduced . H ow w ould this benefit the taxpayers? As the U.S. pub lic is in the process of painfully discovering, the ta x payers u ltim ate ly stand beh ind federal deposit insurance, the S I00 billion estim ated loss of the FS L IC being a case in point. Since ou r recom m ended changes w ould m ake the F D IC stronger and less likely to becom e insolvent, all ta x payers w ould benefit. M oreover, since an essential aspect of ou r proposal is th a t all banks opera te u n d er the sam e cap ita l an d co-insurance rules—m eaning th a t no bank is too big to fail— sm aller bank ing organizations, w hich cu rren tly are confronted w ith unfair and un fo rtu n a te com petition , w ould also benefit.

All banks w ould lose to the ex ten t the expected losses of the FD IC w ere lowered, thus reducing the net subsidy to the bank ing industry . Banks, an d of course depositors, w ould


also lose the b lanket insurance p ro tection now offered depositors, m aking them less com petitive w ith the m yriad of un insured savings instrum ents. W ith a be tte r system of deposit insurance in place, though, bank powers could be expanded w ith less concern abou t soundness issues, th a t is, less concern th a t m oral h aza rd was being spread to nonbank lines of business.

n balance, the benefits of this proposal far outw eigh the costs. T h a t there will be costs and th a t they can n o t be avoided should be clear. W e see no way to

m ake progress on m oral hazard w ithou t increasing the po ten tia l for depositor instability. If the experience in the savings an d loan industry, however, is any ind ication of the po ten tia l p roblem s in banking, some tradeoff is w arran ted .

Endnotes

'T he point that reform should logically precede further deregulation was forcefully made as early as 1983 by Kareken.

2This essay deals with bank regulation in general, and the Federal Deposit Insurance Corporation (FDIC) in particular. But, most of our policy recom m endations would be equally applicable to the savings and loan industry and their insurer, the FSLIC. W hat is not discussed here is the current financial crisis of the FSLIC, a problem which is (thankfully) unique to that institution.

3D ata for uninsured deposits in failed banks tha t were purchased by other banks are not available. We estimate uninsured deposits as the difference between total assets and total insured deposits, based on the assumption tha t equity of failed banks is zero.

4T he m oral hazard problem is, in fact, more extreme with deposit insurance than it is with m any forms of private insurance. The FDIC does not prohibit troubled banks from buying more insurance (that is, acquiring more deposits). This is analogous to allowing the owners of a factory to buy more fire insurance when their factory is on fire.

5W hile bank stock owners may be able to effectively diversify their risks, this is m uch more difficult for the senior m anagem ent of banks. T h a t is so because when a bank fails it may reflect on their skill as managers, and thus on the value of their hum an capital. This point is sometimes raised as an im portant force countervailing the incentive

effects of moral hazard. However, if bank owners genuinely w ant managers to pursue high-risk strategies, it seems they can get their wish. O ne obvious way is to pay m anagers sufficiently high current salaries to offset their risk of loss should bankruptcy occur in the future.

6The high potential earnings in comm ercial banking were un doubtedly dissipated, in part, by subsidizing loan rates and by non-price competition for depositors. But the monotonously low failure rate through the 1970s strongly supports the notion tha t bank owners were still doing well.

7The protective subsidy notion is more fully discussed and defended in Benveniste, Boyd and G reenbaum (1988).

8Continuing this trend, on Jan u ary 18, 1989, the Board of Governors ruled tha t five m ajor banking firms could underw rite and deal in corporate debt. T he Board also indicated at tha t time tha t (if all went well with debt underw riting) it would consider perm itting banking concerns to underw rite corporate equities w ithin about a year. In a previous decision (April 30, 1987), the Board approved applications to underw rite com m ercial paper, m ortgage-backed securities, municipal revenue bonds and consum er-related receivables. Even earlier, discount brokerage was determ ined to be a permissible activity for banking organizations on Jan u ary 7, 1983.

9100 percent reserve banking was proposed by Simons (1936) and later by Friedman (1959).

10In theory, at least, the incentive effects of closing banks before they fail are much like those of the protective subsidy.

11 We are not suggesting tha t banks should be kept open w hen all available information indicates th a t the value of their liabilities exceeds the value of their assets. This policy invites end-gam ing strategies on the part of bankrupt institutions, and is in large part to blam e for the recent losses of the FSLIC.

12In 1988, new capital guidelines were announced for banks in the U nited States and a num ber of o ther countries, pursuant to an international agreem ent in Basle, Switzerland. T he Basle Agreem ent calls for m inim um capital of 7.25 percent of assets by the end of 1990 and 8 percent of assets by the end of 1992. The new capital requirements are risk-progressive, a t least in terms of asset risk. Five risk classes are established for assets and off-balance sheet items. Each is weighted from 0 to 1.0 w ith cash and short-term U.S. Treasury bills receiving the lowest weight, w hereas most bank loans receive the highest weight. All o ther assets are assigned weights of 0.1, 0.2, or 0.5, depending on their assessed risk. For a detailed discussion of the Basle Agreement risk classifications, see Federal Reserve System (1988).

13We claim no originality for this proposal. In fact, it has some historical precedent. Co-insurance was part of the original deposit insurance plan that was to go into effect on Ju ly 1, 1934 (FDIC, p. 44). Deposits up to SI 0,000 for each depositor were to be fully insured, over $10,000 but under $50,000 were to have 75 percent coverage, and over $50,000 only 50 percent coverage. This plan, however, was superseded by a new plan tha t was part of the Banking Act of 1935 which provided only full coverage up to $5,000.

14The seminal work on time inconsistency is K ydland and Prescott (1977). For a less technical discussion of this problem , see C hari (1988).


Bibliography

Association of Reserve City Bankers. 1988. Beyond capital regulation: Strengthening the FDIC insurance fund and systemic liquidity. Recomm endations of the Special Task Force, Asset/Liability Committee (M arch), Chicago.

Benveniste, Larry, Jo h n H. Boyd and S tuart G reenbaum . 1988. Bank capital regulation. M onograph prepared for Association of R eserve City Bankers, Banking Research Center, Conference on Bank C apital Issues, Dec. 14-16, Northwestern University, Evanston, 111.

Boyd, Jo h n H. and Stanley L. G raham . 1988. The profitability and risk effects of allowing bank holding companies to merge with other financial firms: A simulation study. Quarterly Review, Federal Reserve Bank of M inneapolis, (Spring): 3-20.

C hari, V .V. 1988. T im e consistency and optimal policy design. Quarterly Review, Federal Reserve Bank of M inneapolis, (Fall): 17-31.

Federal Deposit Insurance Corporation. 1984. The first fifty years. W ashington, D.C.

Federal Reserve System. 1988. Capital; risk-based capital guidelines. 12CFR P art 225, A ppendix B. [Regulation Y; docket #R-0628].

F riedm an, M ilton. 1960. A Program for Monetary Stability. New York, New York: Fordham University Press.

Friedm an, M ilton and A nna J . Schwartz. 1963. A monetary history o f the United States, 1867-1960, Princeton, New Jersey: University Press.

K areken, Jo h n H. 1983. Deposit insurance reform or deregulation is the cart not the horse. Quarterly Review, Federal Reserve Bank of M inneapolis, (Spring): 1-9.

Keeley, M ichael C. 1988. Deposit insurance, risk, and m arket power in banking. W orking Paper 88-07. Federal Reserve Bank of San Francisco.

K ydland, Finn E. and E dw ard C. Prescott. 1977. Rules rather than discretion: T he inconsistency of optim al plans. Journal o f Political Economy 85 (June): 473-91.

Lucas, R obert E., J r . 1981. Studies in Business-Cycle Theory. Cambridge, Mass: T he M IT Press.

Shadow Financial R egulatory Comm ittee. An outline of a program for deposit insurance reform. D ecem ber 5, 1988. Statem ent No. 38. M id America Institute for Public Policy Research, Chicago.

Simons, Henry. 1936. Rules versus authorities in m onetary policy. Journal o f Political Economy 44 (February): 1-30.

For additional copies contact:

Public AlfairsFederal Reserve Bank of M inneapolis M inneapolis, M innesota 55480


Earnings and Expenses 19

Directors 20

Officers 21

Statement of Condition 18


Statement off Condition (in thousands)

December 31, December 31,

Assets1988 1987

Gold Certificate Account $168,000 $169,000Special Drawing Rights Certificate Account 66,000 66,000Coin 11,291 13,110Loans to Depository Institutions Securities:

11,884 9,750

Federal Agency Obligations 99,235 113,526U.S. Government Securities 3,328,425 3,290,251

Total Securities $3,427,660 $3,403,777Cash Items in Process of Collection Bank Premises and Equipment-

382,560 435,370

Less: Depreciation of $27,704 and $24,533 33,631 34,543Foreign Currencies 282,968 256,476Other Assets 77,106 66,936Interdistrict Settlement Fund 1,010,604 (2,890)

Total Assets $5,471,704 $4,452,072LiabilitiesFederal Reserve Notes1 Deposits:

$4,124,053 $3,042,763

Depository Institutions 807,205 847,699Foreign, Official Accounts 4,650 4,950Other Deposits 1,984 16,256

Total Deposits $813,839 $868,905Deferred Credit Items 352,150 370,656Other Liabilities 47,970 44,538

Total Liabilities $5,338,012 $4,326,862

Capital AccountsCapital Paid In $66,846 $62,605Surplus 66,846 62,605

Total Capital Accounts $133,692 $125,210Total Liabilities and Capital Accounts $5,471,704 $4,452,072

Amount is net of notes held by the Bank of S804 million in 1988 and S992 million in 1987.


Earnings and Expenses (in thousands)

For the Year Ended December 31 1988 _____1987

Current EarningsInterest on U.S. Government Securities and

Federal Agency Obligations $261,532 $240,914Interest on Foreign Currency Investments 9,342 11,348Interest on Loans to Depository Institutions 3,611 2,553Revenue from Priced Services 37,362 36,599All Other Earnings 446 7,920

Total Current Earnings $312,293 $299,334

Current ExpensesSalaries and Other Personnel Expenses $29,324 $27,437Retirement and Other Benefits 5,912 5,256Travel 1,113 1,001Postage and Shipping 5,566 5,653Communications 458 497Materials and Supplies 2,129 1,887Building Expenses:

Real Estate Taxes 2,334 2,267Depreciation—Bank Premises 1,078 1,065Utilities 812 734Rent and Other Building Expenses 1,267 1,426

Furniture and Operating Equipment:Rentals 613 687Depreciation and Miscellaneous Purchases 4,768 4,600Repairs and Maintenance 2,300 2,085

Cost of Earnings Credits 6,931 6,083Other Operating Expenses 2,558 2,896Net Shared Costs Received from Other FR Banks 1,713 1,613

Total $68,876 $65,187

Reimbursed Expenses2 (3,654) (3,138)

Net Expenses $65,222 $62,049

Current Net Earnings $247,071 $237,285Net Additions (Deductions)3 (16,711) 58,626Less:

Assessment by Board of Governors:Board Expenditures 2,596 2,649Federal Reserve Currency Costs 2,368 2,480

Dividends Paid 4,004 3,694Payments to U.S. Treasury 217,151 285,618

Transferred to surplus $4,241 $1,470

Surplus AccountSurplus, January 1 $62,605 $61,135Transferred to Surplus—as above 4,241 1,470

Surplus, December 31 $66,846 $62,605

Reimbursements due from the U.S. Treasury and other Federal agencies; SI,220 was unreimbursed in 1988 and $1,549 in 1987.

3This item consists mainly of unrealized net gains (losses) related to revaluation of assets denominated in foreign currencies to market rates.


Directors December 31, 1988

Federal Reserve Bank of Minneapolis Helena Branch

Michael W. Wright Marcia S. AndersonChair and Federal Reserve Agent Chair

John A. Rollwagen Warren H. RossDeputy Chair Deputy Chair

Class A Elected by Member Banks

Charles W. EkstrumPresident and Chief Executive Officer First National Bank Philip, South Dakota

Joel S. HarrisPresident Yellowstone Bank Billings, Montana

Duane W. RingPresidentNorwest Bank La Crosse, N.A.La Crosse, Wisconsin

Class B Elected by Member Banks

Bruce C. AdamsPartnerTriple Adams Farms Minot, North Dakota

Richard L. FalconerDistrict Manager-Finance US West Communications Minneapolis, Minnesota

Earl R. St. John, Jr.PresidentSt. John Forest Products, Inc.Spalding, Michigan

Class C Appointed by the Board of Governors

Delbert W. JohnsonPresident and Chief Executive OfficerPioneer/NorelkoteMinneapolis, Minnesota

John A. RollwagenChairman and Chief Executive Officer Cray Research, Inc.Minneapolis, Minnesota

Michael W. WrightChairman, Chief Executive Officer and President Super Valu Stores, Inc.Minneapolis, Minnesota

Federal Advisory Council Member

DeWalt H. Ankeny, Jr.Chairman and Chief Executive Officer First Bank System, Inc.Minneapolis, Minnesota

Appointed by the Board of Governors

Marcia S. AndersonPresidentBridger Canyon Stallion Station, Inc. Bozeman, Montana

Warren H. RossPresident Ross 8-7 Ranch Chinook, Montana

Appointed by the Board of Directors Federal Reserve Bank of Minneapolis

F. Charles MercordPresident and Managing Officer First Federal Savings Bank of Montana Kalispell, Montana

Noble E. VosburgPresident and Chief Executive Officer Pacific Hide and Fur Corporation Great Falls, Montana

Robert H. WallerPresident and Chief Executive Officer First Interstate Bank of Billings, N.A. Billings, Montana


Officers December 31, 1988

Federal Reserve Bank of Minneapolis

Gary H. SternPresident

Thomas E. GainorFirst Vice President

Melvin L. BursteinSenior Vice President and General Counsel

Leonard W. FerneliusSenior Vice President

Ronald E. KaatzSenior Vice President

Arthur J. RolnickSenior Vice President and Director of Research

Sheldon L. AzineVice Presidentand Deputy General Counsel

Phil C. GerberVice President

Bruce J. HedblomVice President

Bruce H. JohnsonVice President

Richard L. KuxhausenVice President

David LevyVice President and Director of Public Affairs

James M. LyonVice President

Susan J. ManchesterVice President

Preston J. MillerVice President and Deputy Director of Research

Clarence W. NelsonVice Presidentand Economic Advisor

Charles L. ShromoffGeneral Auditor

Colleen K. StrandVice President

Theodore E. Umhoefer, Jr.Vice President

Kathleen J. BalkmanAssistant Vice President

John H. BoydResearch Officer

Robert C. BrandtAssistant Vice President

James U. BrooksAssistant Vice President

Marilyn L. BrownAssistant General Auditor

James T. DeusterhoffAssistant Vice President

Richard K. EinanAssistant Vice President and Community Affairs Officer

Jean C. GarrickAssistant Vice President

James H. HammillAssistant Vice President and Secretary

Caiyl W. HaywardAssistant Vice President

William B. HolmAssistant Vice President

Ronald O. HostadAssistant Vice President

Thomas E. KleinschmitAssistant Vice President

Keith D. KreycikAssistant Vice President

Roderick A. LongAssistant Vice President

Richard W. PuttinAssistant Vice President

Thomas M. SupelAssistant Vice President

Claudia E. SwendseidAssistant Vice President

Kenneth C. TheisenAssistant Vice President

Thomas H. TurnerAssistant Vice President

Carolyn A. VerretAssistant Vice President

Joseph R. VogelChief Examiner

Warren E. WeberResearch Officer

William G. WursterAssistant Vice President

Helena Branch

Robert F. McNeillsVice President and Manager

David P. NickelAssistant Vice President


Federal Reserve Bank of Minneapolis

250 Marquette Avenue

Minneapolis, Minnesota 55480


1988 frb minneapolis

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