Carnegie-Rochester
North-Holland
Conference Series on Public Policy 38 (1993) 1-34
Deposit insurance reform:
functional approach*
a
Robert C. Mertont
Harvard University,
Boston,
MA 02163, U.S.A.
and
Zvi Bodie
Boston
University,
Boston,
MA 02215, U.S.A.
Abstract
The current
there
and
illiquid
have
been,
source
that
bank
loans
to finance
such
costs
used
if any, exist
such
by the FDIC
those
insured
created
by using
insured
lending
activities
of banks,
in today’s
financial
the current
solution
is for commercial
as debt,
preferred
stock,
or accounts
that
to institutions
bills or their
has a basic structural
insured
to collateralize
synergy
for maintaining
an efficient
insurance
the deposits
the commercial
benefits,
instruments
be limited
of deposit
between
at one time,
significant
that
system
is a mismatch
lending
and equity,
collateralize
deposits.
deposits
because
“opaque”
There
may
as the primary
but we see no evidence
system.
institutional
problem
and the
There
structure.
to be financed
and that
deposits
are,
by standard
deposit
with
however,
We conclude
insurance
U.S. Treasury
equivalent.
1. Introduction
There is widespread
of deposit insurance
agreement in the United States today that our system
is a major economic problem, but there appears to be
*We thank the Carnegie-Rochester
Conference participants,
and especially George Benston, Mark Flannery, Ed Kane, George Kaufman, Robert King, Allan Meltzer, George
Pennacchi, and Charles Plosser, for their helpful comments.
t Correspondence to: Robert C. Merton, Harvard University, Morgan 397, Soldiers
Field, Boston, MA 02163.
0167-2231/93/$06.00 0 1993 - Elsevier Science Publishers B.V.
All rights reserved.
no general consensus about the cause or the solution of the problem. Politicians, journalists,
and academics have offered many different opinions and
proposals. In this paper, we do not attempt to provide either a comprehensive survey or critical
particular
analytical
review of all or even most of them.
Instead,
we apply a
framework to arrive at a specific proposal for reform and
then use that framework
to evaluate
alternative
proposals.’
To further focus
the analysis, we address deposit insurance only as it relates to commercial
banking in the United States.’
In discussions of deposit insurance, it is common practice to use the cost to
the U.S. taxpayer of bailing out the depositors of failed depository institutions
The true cost to our society, however, is
as the measure of the problem.
the misallocation of investment and the unintended redistribution
of income
and wealth caused by the current system.
The current deposit-insurance
system, accounting rules, and regulatory procedures can encourage excessive
risk-taking.
In some cases, they may even encourage fraud and abuse. Any
proposed cure must address those true social costs. Thus, a proposed solution
that leaves intact the incentives to misallocate
and randomly redistribute
resources is no solution at all.
As is evident from the literature, there are two fundamentally
different
perspectives and frameworks for analysis of deposit insurance and the banking system. The first takes as given the existing basic commercial-banking
institutional
structure, and views the objective of public policy as helping
the institutions currently in place to survive and flourish. This institutional
perspective a.ppears to be the one generally taken by banking practitioners
and regulatory policymakers. 3 The alternative approach takes as given the
economic functions performed by commercial banks and deposit insurance
and asks what is the best institutional
structure
to perform those functions.
In contrast to the institutional
perspective, this functional perspective does
not posit that existing institutions,
whether operating or regulatory, should
necessarily
be preserved
as presently
constituted.
As is the tradition in neoclassical
economics generally, the functional
perspective treats the existence of households, their tastes, and their en1For a general overview of deposit-insurance
Barth,
Brumbaugh,
framework
and Litan
of our paper
is developed
c). In the banking literature,
Posner
(1978),
Gorton
(1992),
Bodie (1992b,c,
3The thrust
reports.
Thus,
system
reform,
Competitive
Section
in Merton
the analytical
and Pennacchi
with the development here.
2We have discussed elsewhere
entitled its February
Banks.
2
The
(1991)
(1991)
specific
and Bodie
(1992),
analytical
(1992a,b
Black,
and
Miller, and
are most closely aligned
as it relates to thrifts.
see J. Barth
System:
and Brumbaugh
of Black (1985),
and Pierce
deposit insurance
the Financial
(1993).
(199213) Merton
thinking is often reflected
the U.S. Treasury
Modernizing
see Barth
approaches
(1992a),
6). More generally,
of policymaker
reform,
and Brumbaugh
See Merton
and Brumbaugh
and
(1988).
in the titles given to government
1991 detailed proposals
for financial
Recommendations
Safer,
for
More
dowments
as “givens,”
tradition
exogenous
does not extend
other economic
to the economic
this fundamental
organizations
system.
However,
right of continued
such as business
firms, markets,
this
existence
to
financial
in-
stitutions, and government regulatory bodies. They are regarded as existing
primarily because of the functions they serve and are therefore endogenous to
the system. Thus, in the functional perspective, institutional form follows its
function. As part of an evolving process of change, it is thus to be expected
that old institutional forms will be superseded by new ones that perform the
underlying
economic
functions
more efficiently.
We therefore begin our analysis by identifying the two core economic
functions performed by commercial banks.4 Commercial banks make loans
and guarantee loans to businesses, households, and governments.5 The types
of loans for which banks are specialists are those that are difficult to assess
without detailed, and often proprietary, information about the borrower.6
These borrowers are reluctant to reveal to the general public the information
which would be necessary for a direct public placement of the debt. The loans
taken by banks are risky and tend to require careful monitoring. Thus, bank
loans are relatively “opaque” assets. ’ They are not traded on the secondary
markets and therefore do not have observable prices. In most cases, proper
valuation of the loans requires nonpublic information about the borrower
so that market values cannot easily be inferred from the prices of traded
debt instruments with similar promised terms.8 Moreover, bank loans may
contain special terms and provisions not typically found in publicly-traded
instruments.
With such a large potential for asymmetric
information,
it
follows almost a fortiori that loans of this type would be illiquid. Our measure
of liquidity is that the larger the bid-ask spread on a security, the less liquid
*As here, Diamond
and Dybvig (1986)
which is transaction
clearing,
(iii) transformation
cards);
issuing liquid deposits.
5According
portfolio
consumer
‘jFor discussion
see Diamond
trend
currency
liquidity
The role of banks in liquidity
by buying
creation
at the end of 1990
banks was: commercial
loans 19%, all other
Fama
“opaque”
in the recent
including securitized
(1985),
however,
(checks,
is discussed
in Section
the breakdown
and industrial
cash
illiquid loans and
3.
of the loan
loans 30%, real-estate
14%.
and James
of asymmetric
information,
(1987).
here in the sense developed
past is for banks to invest
loans of other banks.
They,
and other means of payment
which creates
Reserve,
of banks.
which is making loans; (ii) liability services,
of the role of banks in the intermediation
(1984),
7We use the term
“The
providing
services,
to the Federal
of U.S. commercial
loans 37%,
fecus on the functions
(i) asset services,
identify three core functions:
To the extent
in depth by Ross (1989).
in marketable
debt instruments
they do so, they are becoming
less
like the institution we define as commercial banks. The bank assets that lend themselves
to being securitized are the ones that are least opaque, such as credit-card
and automobile
loans.
Corporate,
for securitization
commercial
real-estate,
and, therefore,
extensive
discussion
Corporate
Finance.
and sovereign
loans are not generally
tend to stay on the balance
of asset securitization,
sheet
see the Fall 1988 issue of Journal
3
acceptable
of the firm.
For an
of Applied
is the security.
A perfectly-liquid
security trades with a zero bid-ask spread.
The other function of banks is to take deposits from customers.
deposits are of two types: transaction deposits and savings deposits.
These
Trans-
action deposits are, by definition, used by bank customers to make payments.
The function of a payments system is to facilitate the exchange of goods and
services at minimal cost. If two parties have agreed on the terms of trade
in a particular transaction
(price, delivery date, etc.)
and both have the
resources
to carry out the trade,
then the function
of the payments
system
is to efficiently implement the trade. In modern economies where individuals and especially business firms engage in many transactions every day, the
costs of acquiring information about the credit risk of every counterparty to
every transaction would be prohibitive. By having specialized intermediaries
whose function is to verify the ability of the parties to make good on their
transaction
commitments,
to credit the appropriate accounts, and to guarantee payment, enormous economies of scale in information-gathering
and
transaction-processing
can be achieved.
To perform this function efficiently the bank provides demand deposits
to customers which are free of default risk regardless of the size of the transaction.
Customers then make payments by writing checks or making wire
transfers against those demand deposits.
To achieve the primary goal of
an efficient payments system, therefore, transaction deposits should be completely free of default risk.g
There may have been at one time efficiency gains from using insured
deposits as the primary source to finance the commercial lending activities
of banks, but we believe there no longer are.” Of course, even if there are
‘There
is some disagreement
among economists
ance is the most efficient way of securing
be widespread
is ultimately
agreement
among economists
the de faclo
insurer
points of view, see Flannery
“Gorton
short-term
and Pennacchi
(1992a)
debt to finance
and illiquid loans.
monitor
finance
debt because
deposit
However,
the government
For a discussion
of the different
and Bodie (1992b,c).
“agency-cost”
those specialized
arguments
institutions
that
for using very
make opaque
that there is no need for this short-term
that are part of the payments
with insured
deposits
of that
system.
would defeat the agency
debt to
Indeed,
purpose
of
have an incentive
to
to “roll over” the debt and continue
to
debt would no longer
the firm in making their decision whether
insur-
there seems to
for a variety of reasons,
and Merton
deposits
the holders
government
system.
deposits.
present several
They show, however,
we would argue that financing
short-term
1991)
in large part
take the form of insured demand
that,
of demand
(1988,
on whether
the payments
the firm.
Benston
and Kaufman
(1988)
argue that if the same institution
that holds a customer’s
deposits also grants loans to that customer, economies of scale and scope can be achieved.
Black (1975) and Fama (1985) appear to make similar claims, although Black (1985)
later seems
an individual
Moreover,
significantly
to reject
such synergies.
carries
all its financial
we are unaware
better
In these times,
accounts
of any widespread
loan terms
to those
it is rare that
including
practice
credit
either
a business
or
with a single bank.
to induce this behavior
who would do so.
4
cards
If, however,
by offering
such potential
no synergistic
benefits
to the linking of risky loans with demand deposits,
there are also no dysfunctional
that maintaining
aspects
of that combination,
the existing institutional
However, there are significant
if
one could argue
structure
is probably
cost-efficient,
costs to maintaining
the status
quo. It is the
fundamental
mismatch between bank demand-deposit
liabilities insured by
the government and the illiquid, risky, and opaque loans collateralizing
those
insured deposits that gives rise to the current deposit-insurance
problem.
We are therefore led to agree with Black (1985), Litan (1987), Pierce
(1991), and Tobin (1985, 1987) that collateral be equal to 100% of transaction
deposits and that collateral should be restricted to U.S. Treasury bills or their
equivalent. ‘* This proposed solution to the deposit-insurance
problem does
not require a “narrow-bank” structure that prohibits institutions which take
transactions
deposits from engaging in other financial activities,
including
risky lending. Indeed, under these collateral conditions, we see no danger to
the safety of deposits from depository firms offering other financial services.
Thus, our proposal does not eliminate any opportunities
for economies of
scope or scale from “one-stop shopping” for consumers of financial services.
We believe that our proposal offers a minimal-cost structure for providing
default-free deposits without subsidies, either advertent or inadvertent.
With
the recommended collateral arrangement,
the cost of providing government
Currently, trading spreads in U.S.
deposit insurance would be negligible.
Treasury bills are only a few basis points, and with the opportunity to net
deposits and withdrawals, depositories should have tiny transaction costs for
processing payments.
With book-entry of the Treasury-security
collateral
at the Federal Reserve, custodial costs for this arrangement should also be
minimal. Furthermore,
firms that offer deposit services would require little
regulation, and there is no need for additional assurance capital.
The lending and loan-guarantee
activities of banks, once separated from
insured deposits as the funding source, could then be carried on without
government restrictions
designed to protect the Federal Deposit Insurance
Corporation
(FDIC),
which insures bank deposits.
The financing of these
lending activities would presumably consist of some combination of common
efficiency gains are really there, our proposal for reform does not rule out lending and
deposit-taking
activities within the same company, provided that the loans do not serve
as collateral for deposits.
In sum, we know of no study showing direct synergistic benefits from having risky loans
serve as the collateral for insured demand deposits.
“Kareken
(1986) also proposes 100% U.S. Treasury collateral for deposits.
However,
his proposal differs because it allows bonds of any maturity
to be used for collateral,
and it does not permit depositories
to engage in other financial activities.
Accompanying
his paper are several discussions of his proposal.
The idea of requiring interest-earning
obligations of the U.S. government
as 100% reserves against bank demand deposits was
proposed by Friedman (1960). His proposal was, however, motivated by the objective of
achieving more effective control of the money supply.
5
and preferred
stock, long-term
and short-term
debt, and convertible
securi-
ties, as determined by competitive market forces. If, as some have suggested,
government intervention is required in the area of commercial lending to
overcome private-market
failures, that intervention can surely be made more
efficient if it is not complicated by the existence of government-insured
demand deposits. ‘* Thus, by changing the institutional structure of commercial
banking-through
separating banks’ lending and loan-guarantee
activities
from their deposit-taking
social benefits
activities,
with no apparent
it is possible to achieve potentially
offsetting
large
costs.
A different approach to solving the deposit-insurance
problem is to maintain the existing structure, but to substitute private insurance of bank deThis could be accomplished
in several
posits for government insurance.
ways. One way is to directly substitute private deposit insurance for FDIC
insurance. l3 Another way is to impose high capital standards on banks. If
agency and tax costs make equity capital “too expensive,” then the government could allow subordinated
debt securities to count as bank capital.14
The subordinated creditors would then be the guarantors of the bank’s deposit liabilities.15
Ultimately, however, the government would still be the
de facto guarantor
of the system. l6 Such a system could be made to work,
“Stiglitz
(1991), for example, argues for government
intervention
to correct private
capital market failure arising from incomplete or asymmetric
information.
However, he
recognizes that the existence of deposit insurance gets in the way. His proposed solution
to the deposit-insurance
problem is to increase bank capital requirements.
We discuss
the problems with this solution in Section 2.3. Flannery (1991) presents a comprehensive
inventory and analysis of the rationale for government intervention
in the banking system.
13See Ely (1990). Eng lish (this volume) documents
the rather unsuccessful
historical
experience with private deposit insurance in the United States. King (1983) discusses an
historical
“experiment”
that occurred in New York State during the period 1840-1860,
in which private insurance of demand deposits coexisted with 100% collateralization
of
demand deposits with U.S. government
securities.
According to King, collateralization
worked much better than private deposit insurance in securing demand deposits against
bank defaults.
14See Benston (1992).
15Any time a loan is made, an implicit guarantee of that loan is involved. To see this,
consider the fundamental
identity, which holds in both a functional and a valuation sense:
Risky Loan + Loan Guarantee c Default-Free Loan
Risky Loan - Default-Free Loan - Loan Guarantee
Thus, whenever lenders make dollar-denominated
loans to anyone other than the United
States government, they are implicitly also selling loan guarantees.
For further discussion,
see Merton and Bodie (1992b,c, Section 1).
16No matter how firm the government’s
commitment
to relying on private markets,
there is a problem of time inconsistency
that limits their effectiveness.
The essence of
the time-inconsistency
problem with respect to deposit insurance is that, under certain
circumstances,
it is socially optimal for the government
to renege on its threat to allow
banks to fail. It is widely acknowledged
that even in countries without formal deposit-
6
but it would be more costly than the proposed 100% default-free collateral
system, with no apparent offsetting benefits. To better understand the nature of these costs, we now turn to a more detailed
analysis of the guarantee
business.
2. Managing
demand-deposit
guarantees”
There are three basic methods available to any guarantor-whether
or government-to
manage its guarantee of bank demand deposits
private
against
failure of the bank:
l Restrict
the asset choice of the bank to ensure an upper boundary on the
riskiness of the bank’s assets.
l Monitor
the value of the bank’s assets with the right to seize them if they
fall below a certain minimum capital standard. Holding fixed the premium
charged for the guarantee, the capital standards required for viability increase with increases in the variance of the value of the bank’s assets or with
increases in the time between audits.
l Set a premium
schedule for the guarantee.
Ceteris Paribas, the premium
rate required for viability increases with increases in the variance of the value
of the bank’s assets or the time between audits.
Although not one of the three methods can work by itself, they can substitute for each other in terms of the degree of intensity of their use. Hence,
there is room for tradeoffs among them. A fundamental
issue is that the
illiquid and opaque nature of the loans held by commercial banks and the
loan guarantees issued by them make it very costly for outsiders to monitor
them and to set appropriate capital standards or deposit-insurance
premiums. As noted, commercial and industrial loans and loan guarantees often
require the lender to have detailed knowledge of the borrowing firm’s operations that cannot be made public.
easily securitized or otherwise resold.
Consequently, those loans cannot be
Their market values cannot therefore
be observed, or at least not observed frequently. In some cases, the market
prices of similar-type debt instruments such as junk bonds can be observed;
in other cases, there are no such cornparables.
bank loans are costly to make and typically
Market-value
assessments
have quite limited
accuracy.
of
insurance schemes, the government is understood to stand behind demand deposits. The
government, therefore, is caught in a paradox of power. For market discipline to work, the
government must bind itself convincingly not to bail out banks that get into trouble. But
the government is too powerful not to intervene. Everyone knows that since government
makes the rules, it can change them, too. Indeed, only an incompetent government would
not intervene to stop a panic. But if t,he government will bail out depositors
there is implicit insurance, even if there is no explicit insurance ez aale.
17This section is based on Merton and Bodie (1992b,c, Section 2).
7
~3:post, then
2.1 Asset
restrictions
As already
discussed,
in our view the most efficient
method
of insuring
the
payments
system against credit risk is to make sure that the collateral
assets
of banks
are closely matched
to the
bank’s
demand-deposit
in both value and risk characteristics
liabilities.
In its strictest
form, this proposal
calls
for the FDIC to require insured banks to completely hedge their demanddeposit liabilities by investing in the shortest-term
U.S. Treasury securities
or their equivalent.
Note that the asset restriction in this
the default-risk characteristics
of the securities held by the
their maturity. If a bank is allowed to invest in long-term
can be subject to considerable interest-rate risk, even if the
default risk.l’
case covers both
insured bank and
bonds, the FDIC
bonds are free of
To the extent that the range of permitted assets backing demand deposits
is extended to include other securities, more resources would have to be put
into the monitoring process.
To illustrate,
consider the effect of allowing
banks to trade in derivative securities-financial
futures, forward contracts,
options, and swaps. The opportunity to take positions in these securities
greatly enhances the ability of banks to quickly reduce their exposure to risk.
However, banks can just as easily use derivative securities to increase their
risk exposure. Even if a bank serves as a simple market-maker in derivatives,
it is not always an easy task to verify that the bank’s match-book is truly
matched, especially when there is credit risk among its counterparties.lg
Allowing banks to trade in derivatives therefore greatly complicates the ability
of outside monitors to determine the net exposure of a bank.
‘“This point is made by McCulloch (1986) in his discussion of Kareken’s (1986) proposed
reform of the banking system.
lgSince 1990 every big U.S. bank has been obliged to disclose certain information regarding its positions in derivatives.
Among this information is a measure called the “credit-risk
amount” or CRA, which is the maximum loss the bank would suffer if every counterparty
to every derivative contract defaulted. In terms of credit-risk exposure, the CRA measure
can be used in the same way as total net loans. According to Grant’s Interest Rale Observer, April 10, 1992, p. 9, the net loans and CRAs for four money-center
banks in 1991
were:
(in $ billions)
Net Loans
CRA
Bankers
Trust
$15.2
25.6
Chase
$65.8
25.2
Chemical
$81.0
22.5
Citicorp
$147.6
29.6
The riskiness of the assets represented
by the CRA may be different from the riskiness
of the loans. Furthermore,
the CRA overstates the default exposure because it does not
recognize the contractual
right of the bank to net all its swap obligations (both gains and
losses) to a defaulting counterparty.
These statistics
nevertheless
show that the potential credit-risk exposure from off-balance-sheet
items warrants significant monitoring by a
guarantor.
2.2 Continuous
If the FDIC
surveillance
has a covenant
with the right to seize collateral
right to monitor
continuously
and seize assets,
shortfall losses can be minimized either by auditing the value of the assets
and seizing them before their value dips below the value of its insured deposits,
or by making sure that the assets accepted
as collateral
always have
a value at least equal to the deposits. The surveillance and seizure system
employed by brokers in protecting themselves against default risk on the part
of their customers is an example of a system that relies almost entirely on
such monitoring.
The futures and options exchanges
and throughout the world employ similar methods.20
in the United
States
A good example to illustrate how monitoring with continuous surveillance
can work effectively to protect the provider of a guarantee is the case of
broker margin loans. It is instructive,
because the system functions with
only a minimal fee for the guarantee provided. When an investor opens a
margin account with a broker and borrows money to buy stocks or bonds, the
broker effectively is in the position of loan guarantor. For example, consider
an investor who invests $100,000 in stocks, borrowing half of the funds from
the broker. In practice, a broker typically borrows the funds that it lends to
investors from a bank (or the commercial paper market) and guarantees the
bank payment in full even if the investor defaults. The loan from the bank to
the broker is collateralized
by all of the broker’s assets. These loans-both
the loan from the broker to the investor and from the bank to the brokerare due on demand.
The broker’s fee for providing its guarantee (that is,
for absorbing the default risk of the investor’s collateralized
loan) and for
servicing the account is embodied in the spread between the interest rate it
charges the margin investor and the interest rate it pays to the bank.
As guarantors,
brokers set two types of capital requirements:
gin and maintenance
margin.
net worth of the investor’s
The initial margin requirement
account
at the time the margin
initial mar-
is the required
loan is made
and the securities purchased. 21 All the securities purchased by the margin
investor remain in the possession of the broker as collateral for the loan,
and the broker calculates the market value of these securities daily (and
sometimes more often on days when there is unusual volatility in price movements).
The net worth of the investor’s
account
is calculated
as the market
“Miller (1990, Section 2.1.2), for example, describes how futures exchanges insure the
parties to a futures contract against contract-default
risk by employing perfected collateral
that is marked to market on a daily basis. There is an additional
layer of protection
against default risk built into the system in the form of a clearing house. All contracts are
formally between the buyer or seller and the exchange clearing house and thus carry that
institution’s
guarantee.
The same is true for exchange-traded
options.
‘lAlthough
the terms are set by individual brokers, the Federal Reserve sets regulatory
minimum levels of initial margin requirements.
9
value of the collateral
less the debt to the broker.
If the net worth of the
account falls below a prespecified fraction of the value of the collateral, called
the maintenance-margin
ratio, the broker notifies the investor that he must
add additional
not respond
curities
investor
equity capital to his account immediately.
to this margin call, the broker exercises
serving as collateral
receives
If the investor does
its right to sell the se-
and pays off the loan out of the proceeds.
the remainder,
if any. Brokers
them substantial
protection
held by investors
are often quite volatile.22
The
find that this system offers
despite the fact that the prices of the securities
The key elements of this system of monitoring margin loans are: (1) the
guarantor has possession of the collateral; (2) the value of the collateral is
recomputed frequently at readily ascertainable
market prices, and (3) the
guarantor has the right to automatically
liquidate the collateral to pay off
the guaranteed liability if the ongoing capital requirement is violated. Each of
these elements is essential for the system to function properly. In particular,
frequent monitoring of the market value of the collateral would be pointless
if the broker did not have the right to seize and liquidate the collateral as
soon as the required maintenance-margin
ratio was violated.
If the FDIC were to implement such a monitoring system for commercial
banks, the costs are likely to be significant.
Effective monitoring requires
that collateral be valued at current market value. Although the concept of
marking to market is straightforward,
its implementation
can be complex
organized
and costly. 23 If the collateral assets are traded in well-functioning
markets such as national stock exchanges and government-securities
markets,
then reliable market values are readily observable, and marking to market is
a relatively low-cost process. However, for the kinds of assets held by banks,
estimates of market prices are subject to significant errors, and reaching
agreement on the proper mark-to-market
procedure is considerably
more
difficult.
These estimation
sured bank.
errors impose risks on both the guarantor
If the errors overstate
values,
the guarantor
and the in-
will not seize as
quickly as it should, and the proceeds realized from seizure will be less than
expected. If the errors understate the values, the bank will be seized a.nd liquidated when it is actually solvent. Thus, a “conservative” valuation method
22Note
that
and therefore
monitoring
volatile
assets,
be quite liquid.
system,
volatility
such
as common
While illiquidity
stocks,
can have small
may be a barrier
bid-ask
to the effective
spreads
use of a
by itself is not a problem.
231ndeed one of the main arguments used by representatives
of the commercial
banks
against maik-to-market
accounting for bank assets is the high cost of implementation
and
the poor quality
abandon
cost of continuing
guaranteed
of the valuation
the concept
to use traditional
demand
estimates.
of market-value
While they seem to view this as a reason
accounting,
we view it as demonstrating
bank assets as the principal
deposits.
10
collateral
to
the high
for government-
from the perspective
of one party to the system will be an “aggressive”
uation method from the perspective
method
should be unbiased.
of the other party.
Protections
val-
Hence, the valuation
for the parties
from measurement
errors in the prices should be provided by other rules of the monitoring
system-such
as the minimum size of the bank’s net worth before seizure is
permitted.
Because
of the natural
over asset valuation,
tension
between the FDIC
a key element
and the insured
of a mark-to-market
system
bank
is that
it
seeks to minimize the opportunities for manipulation.
Especially if its assets
are traded infrequently,
the bank has information about their true values
that is not costlessly available to other parties, including the guarantor.
As
indicated, the bank’s incentives favor biased-high estimates of prices of its
assets and biased-low estimates of the prices of its liabilities. Thus, while the
bank may have information that could improve the accuracy of the valuation,
it may be optimal to neglect its inclusion in the mark-to-market
estimates
if inclusion of this information allows too much discretion on the part of the
bank. That is, the accuracy of the valuation procedure is important, but just
as important is that the procedure be known, agreed upon by both parties
in advance, and difficult to manipulate.
In sum, a proper mark-to-market
model is one that, specified ex ante, gives the best estimate of market price,
using verifiable data.
A word on book values in a monitoring system.
It is sometimes suggested that circumstances
in which estimates of market prices are “noisy”
are ones that favor using book values-that
is, amortized acquisition cost.
This seems to us to be a non-sequitur.
We are not aware of scientific evidence that book values are the best estimates of market prices, especially
for financial
assets of the kind held by commercial
banks.24
The evidence
on
marketable junk bonds, which are reasonably close substitutes for many of
the types of loans held by banks, points in the opposite direction. Junk-bond
prices fluctuate substantially
over time. It is therefore highly unlikely that
the best-fitting unbiased, nonmanipulatable
model would produce values for
bank loans that remain virtually
constant
(around predictable
amortized
ac-
quisition cost) over time. Standard accounting rules for marking down book
values of assets, such as crea.ting a reserve for bad loans, are usually subject
to considerable
only after
management
a considerable
24M. Barth’s
(1991)
discretion,
and their application often occurs
in value has already taken place.25 The
decline
empirical
findings
are that “.
market
value accounting
ment securities is significant in explaining banks’ share prices.
“The
FDIC’s standard practice, before the Deposit Insurance
to close banks
when their
Hetzel (1991, p. 13) reports
average
bank’s
book-value
capital-to-assets
Thus,
Reform
reached
that for 1,000 banks which failed between
loss ratio was 27% (the loss to the FDIC
assets).
ratio
divided
it would seem that the book
11
for invest-
.” (p. 2).
by the book
Act of 1991, was
zero.
Nevertheless,
1985 and 1991, the
value of the failed
values of assets provide
biased-high
FDIC should therefore be reluctant to let an insured bank use book values
for illiquid assets. 26 There is a certain irony that the assets with the most
uncertainty about their values would be valued by a book system which produces almost no variation in price.
Apart from the fact that most loans in a bank’s portfolio have no observable price, another difficulty in applying this model to commercial banks is
the illiquidity of the debt instruments that do have observable prices. The
relevant market price to be used in valuing the bank’s assets for these purposes is the price at which they can be sold-the
bid price. As long as assets
are marked to market at the bid price, the illiquidity of an asset serving as
collateral is not a problem for the guarantor. However, illiquid assets (which
by definition have a large bid-ask spread) are not suitable as collateral for
guarantees of demand deposits because the bunk is vulnerable to having the
asset seized and liquidated when the bid price falls, even if the average of the
bid and ask prices falls by a relatively small amount.27 The spread cost from
this “bid-ask bounce” is a deadweight loss to the collectivity of the bank and
the FDIC. Thus, if it is large and the chances of a violation are not negligible,
this form of handling guarantee risk is inefficient for illiquid assets.
2.3 Capital
requirements
The measure of capital to be used as a trigger for seizure of assets should
include only the value of assets that can be realized in a liquidation,
net
value or other
of any liquidation costs. To the extent that “going-concern”
intangibles can be preserved in a liquidation,
they should be included in
capital, Otherwise, they should be excluded.
If capital
is large relative
to the value of insured customer
claims,
then
premiums charged by the guarantor can be low, and surveillance
can be
done less frequently.
Since this saves surveillance costs, perhaps a lowercost solution for the FDIC would be to simply require insured banks to
have large amounts of capital in the form of either equity or subordina.ted
debt. However, this solution may be considerably less attractive upon closer
examination.
The amount of capital
a nontrivial cost.
required
can be quite large, and it has
estimates of their market values, at least in financially distressed banks.
26As M. Barth (1991) interprets
her empirical results, mark-to-market
accounting for
only a subset of assets and liabilities of a bank may significantly
distort its reported
financial position.
Hence, all assets, not just the easily valued liquid ones, should be
marked to market.
27For example, suppose that an investor buys an illiquid asset at an ask price of $100
when the bid price is $50. Suppose that the price subsequently
drops to $75 ask and $25
bid. If a margin call occurs and the asset is liquidated, the total loss in value is $100 $25 = $75, even though the average of the bid and ask price has declined by only $25.
12
First,
consider
insurance
the amount
of deposits,
depositors
of capital
required.
the amount of investor
freedom from default risk increases
In the absence
capital
required
with increases
of FDIC
to assure the
in the volatility
of the underlying asset portfolio or the amount of time between audits. For
the kinds of assets held by commercial banks, the volatility can be quite
high. We know that for junk bonds, which are similar to some commercial
bank loans, the standard deviation of the percentage change in price is large,
Portfolio diversification
helps to reduce the risk,
from lo-30%
per year.
but common factors across these bonds create positive covariances in their
returns, which limit the amount of risk reduction.
Much the same point
holds for commercial real-estate loans. Uncertainty
about the true market
value of the loans effectively makes the variance rate larger still. If careful
mark-to-market
audits are infrequent, the capital required to make default
exposure
negligible
can easily exceed 20% of insured deposits.28
Moreover, setting appropriate capital requirements means that regulators
would have to make assessments of the riskiness of bank assets. This is very
difficult to do even if the assets were traded securities that are relatively
“transparent.”
It is even a harder task for the opaque assets actually held by
banks. The costs-both
private and social-of
setting capital requirements
at the wrong level can be substantial. *’ In the case of the thrifts, we have
seen the result of setting them too low. But there is also a cost of setting
them too high. Furthermore,
single-premium
rates accurately set on some
notion of “average-asset
risk” can nevertheless distort investment decisions
among accepted asset classes, often causing too much investment
risk assets and too little investment in lower-risk ones.
in higher-
To see why bank capital provided for assurance purposes has a net cost
even if it is invested in assets that earn a fair market rate of return, consider
the equity-capital
choice. As an empirical matter, financial intermediariesboth insured and uninsured-do
not typically have large amounts of equity
capital relative to the size of customer liabilities. One theoretical explanation
for this behavior is the agency and tax costs associated with equity financing
of any corporate enterprise.
The very characteristic
of the equity cushion
?Stiglitz (1991),
to cover virtually
However,
against
perhaps somewhat
all contingencies,
with asset volatility
only a “two-sigma”
place each year.
determined
the frequency
mentions
event,
2gSetting
specifying
point is that
both
distorting
an “adequate”
the volatility
of careful mark-to-market
capital
marked
to market.
audits.
through
allocation
13
capital
ratio
assets’
“true” returns
audits
takes
cannot
returns
Since the values of most traditional
government
as setting
coverage
audit of all assets
of the underlying
and the cost of mark-to-market
requirements
effects on resource
be reliably
even if a full mark-to-market
assets are hard to assess, it is difficult to measure
both their volatility
a capital ratio of 20% as sufficient
of even 10% per year, this ratio provides inadequate
The more general
without
casually,
even when loans cannot
on those assets,
be
and
bank
and hence
are high.
regulation
has the same potentially
prices by regulation.
that
makes
it attractive
to the guarantor
of the bank have no contractually
future cash flows-is
shareholders
specified
the characteristic
of the bank-that
shareholders
claims to the firm’s current
that creates
who provide that equity cushion.30
or
a moral hazard for the
The resulting
agency and
tax costs are thus the costs of using a large equity cushion as an alternative
to more frequent surveillance.
The agency and tax costs associated with using equity for assurance capital can be significantly reduced by the use of debt, because debt instruments
require the firm to make contractually
specified payments in the future, and
those payments are tax-deductible
for corporations.
The use of subordinated
debt thus seems to offer a simultaneous lower-cost solution to the requirements of both the providers of capital and the FDIC.31
But there are problems with subordinated
debt too. The use of subordinated debt effectively substitutes private guarantees for FDIC deposit
insurance. 32 Private subordinated creditors will then monitor banks in addition to (or instead of) government regulators.
As long as the government
is ultimately
responsible for the guarantees,
private creditors will always
attempt to get “in front” of the government in case of a failure of the insured bank. Debt instruments, such as corporate bonds, often offer investorcreditors ways of getting their cash payments out of a troubled institution
before the FDIC can-high-coupon
payments, call provisions, sinking funds,
and put-option provisions are examples.
Furthermore,
subordinated
creditors may become aware of the financial difficulties of an insured bank before
the FDIC, especially if the FDIC has reduced its surveillance activities to
save costs.
It may be in the interests of both shareholders and subordinated
creditors to use the bank’s “good assets” to satisfy the uninsured creditors while
leaving the “bad assets” for the FDIC. Thus, banks in financial distress will
tend to liquidate assets to meet interest and maturing principal payments
on subordinated debt to avoid immediate bankruptcy in the hope that conditions will change. The assets liquidated will tend to be the ones with the
highest market-to-book
value so as to minimize the impact of those liquidations and payments on the bank’s (book-value) capital. This leaves the bank
with a disproportionate
share of assets which tend to have low market-to-
30The only control shareholders
have over management’s
decisions (including the distribution of future payments of dividends) is their right to elect management.
See Jensen and
Meckling (1976) and Jensen (1986) for further discussion of the agency problem associated
with equity finance and corporate governance.
31Some propose that banks be required to maintain a minimum level of subordinated
debt as a way to impose market discipline on banks that undertake excessive risks in their
asset allocations.
See Evanoff (1991), Keehn (1989), and Wall (1989).
32As explained in footnote 15, any debt instrument
is equivalent to default-free
debt
less a guarantee provided by the creditor.
14
book values.
These
“low-value”
assets are the ones that will be available
to
the FDIC to offset losses from coverage of deposits. Such “asset-stripping”
behavior is widely acknowledged to occur in cases of financial distress and
is very difficult to prevent. 33 Another difficulty in relying on subordinated
debt in the United
States
is the uncertainty
surrounding
actual
priority
of
FDIC
claims in the event of financial distress. As we know from the work
of Tufano (1991), th e g eneral problem of determining seniority is not new.34
Bankruptcy judges have wide latitude in combining creditor classes to form
larger ones which are treated pari passv. In recent times, the courts have
interpreted
the bankruptcy
laws in ways that
create
considerable
ambigu-
ity about the priority of the guarantor’s claims in the event of bankruptcy.
In two recent cases, the courts have decided that the claims of the Federal
agencies that have assumed the guaranteed deposit liabilities of failed thrifts
and the guaranteed annuities of bankrupt pension-plan sponsors are to be
treated pari passu with those of other creditors under Chapter 11 of the Federal bankruptcy code. 35 It is therefore important for the guarantor to monitor
the value of assets serving as collateral, and-in
the event of a violation of
the required capital ratio-to
seize them before the other liability-holders
of
the firm cause the firm to seek bankruptcy-law
protections.
Thus, unless the
bankruptcy laws are changed to remedy the problem of settling the priority
of claims for firms in financial distress, high capital requirements in the form
of subordinated debt may not be a good substitute for aggressive monitoring
by the guarantor.
Finally, there is the issue of whether private parties would be willing to
provide banks with the assurance capital necessary to replace FDIC guarEven with FDIC insurance, new capital has been flowing to the
antees.
institutions
competing with banks rather than to banks.36 Under the cur?See
Baldwin
As reported
support
(1991)
in footnote
for evidence on the practice
25, the average
of asset-stripping
in the thrift industry.
loss ratio of 27% by FDIC
lends further
empirical
for this claim.
?Xrfano
United
(1991)
States
s h ows that over a hundred
were grappling
years ago, creditors
with this issue.
Some of the major
of the railroads
financial
in the
innovations
of
that period-preferred
stock, income bonds, and voting trusts-were
motivated primarily by the need to find efficient ways to resolve financial distress without incurring the
deadweight
35The
Bank,
LTV.
losses associated
with bankruptcy
first is the case of the Resolution
and the second
Apparently,
proceedings.
Trust
is the case of the Pension
the FDIC
has accepted
Corporation
Benefit
the view that
against
Guaranty
Oak ‘Dee Savings
Corporation
it does not have priority
against
claim
over other bank creditors since it has asked Congress on more than one occasion to provide
legislation giving it seniority. Clearly, subordinated
debt has little use as “cushion” capital
if it is not truly subordinated
36Keeley (1990)
the past 20 years.
industry
to the FDIC’s
claims.
pr esents evidence that bank stocks have been losing market value for
He attributes
this to increasing competition
both within the banking
and with nonbank
alternatives.
15
rent banking structure
in the United States,
a typical cost estimate
even” is 200-400 basis points above the rate paid on deposits.
expenses of a money-market fund are about a tenth or 20-40
to “break
In contrast, the
basis points per
year. In order to make banks more profitable and therefore better able to attract new capital, some proponents of the high-capital-requirements
approach
have suggested allowing banks to engage in a wider range of activities.37
However, as we have seen, greater latitude in asset choice for banks makes
monitoring them more costly. Moreover, from the functional perspective,
this expansion of activities only makes sense if there are gains in efficiency
(i.e., synergies) from having them combined in one institution without “fire
walls .”
2.4 Risk-based
premiums
An alternative
method of managing
a viable guarantee
business is to charge
risk-based premiums, as in the property and casualty insurance industry. A
precondition for the success of a system of risk-based premiums for deposit
insurance is that the FDIC be able to measure the values of assets and liabilities and control the volatility of the value of the collateral-asset
portfolio.
For risk-based premiums to work, asset variability need not be reduced to
zero, but it does have to be known (or at least bounded) and not subject to
significant unilateral change by the insured bank after the premium has been
set. If the insured bank can unilaterally change the variability of the asset
portfolio ez post, then the FDIC faces a problem of moral hazard.38
There is a substantial and sophisticated academic literature on applying
the methodology of contingent-claims
pricing to deposit insurance.3g
This
methodology offers a consistent way of determining risk-based premiums and
37This
sounds
remarkably
similar
to the proposals
the 1980s. Such expansion
cost of the thrift bailout.
in permitted
For analysis
Bartholomew,
(1990)
ssFor
and Bradley
a discussion
Greenbaum,
academic
and Thakor
literature
perhaps
the most
and Wall (1989)
hazard
problem.
incentives
create
and analysis
(1992)
on deposit
difficult
propose
John,
and Merton
and Merton
insurance
(1990,
throughout
for banks not to increase
this same incentive
problem
Section
the thrifts
(1991)
the volatility
Section
in
3.2).
Evanoff
requirements
Indeed,
can be found in Keeley (1990),
(1991),
see Chan,
much
Keehn
tax structure
assets.
Other
Merton
(1978),
of the
this problem
to help control
design a convex
of their
6).
for guarantors,
the 1980s stressed
insurer.
using subordinated-debt
and Senbet
to “save”
and Bodie (1992b,c,
of this moral-hazard
one for the deposit
John,
designed
activities is likely to have greatly increased the
of this point with respect to thrifts, see Barth,
as
(1989),
this moralto create
structures
that
and Pennacchi
(1987a).
3gSee, for example,
(1988)
1992a),
Acharya and Dreyfus (1989), Crouhy and Galai (1991), Cummins
Jones and Mason (1980), M arcus and Shaked (1984), Merton (1977, 1978, 1990,
Osborne and Mishra (1989), Pennacchi (1987a, 1987b), Bonn and Verma (1986),
Selby, Franks, and Karki (1988), Sharpe (1978), Sosin (1980),
also the entire September 1991 issue of the Journal of Banking
16
and Thomson
and Finance.
(1987).
See
relating
them to a bank’s capital and asset composition.
is that
deposit
asset portfolio
deposits
insurance
is isomorphic
being the underlying
corresponding
The essential
to a put option,
security
to the exercise
insight
with the bank’s
and the value of the insured
price.
While
we are not aware of
any country where the contingent-claims
approach is currently used to set
deposit-insurance
premiums, the U.S. Offi ce of Management and Budget has
been using it since 1991 to estimate the federal government’s liabilities due to
FDIC and other government
guarantee
programs.40
But, the “opaqueness”
of
corporate and commercial real-estate loans presents considerable difficulty in
applying any type of valuation model for establishing appropriate risk-based
premiums.
In concluding this section, we note that recent legislation to protect taxpayers against a repeat with the banks of the costly thrift bailout seems to
rely primarily on strengthening
the capital base of insured depositories.41
This approach appears to be predicated on the objective of strengthening
the current structure of commercial banks. We see this as exemplifying the
“institutional”
perspective of analysis that takes maintenance of the current
institutional
structure as a primal postulate and seeks to make that given
structure work as well as it can. Applying a functional perspective, we found
a superior solution that requires changes in the institutional
structure. However, absent such changes in the structure, the proposal to strengthen the
capital base is a major improvement over the current system, because it calls
for comprehensive market-value accounting, a strict monitoring system, and
establishment
of risk-based premiums. Moreover, the Danish experience with
a system of mark-to-market
accounting and strict enforcement of capital requirements seems to work for them. 42 Danish banking authorities
pursue
a very aggressive policy of seizing banks that violate capital standards and
reselling
them
to new owners while the bank’s
equity
still has significant
market value. Given the historical record on forbearance for both thrifts and
banks, there is reason to question whether such an aggressive seizure policy
to protect the FDIC would be tolerated in the United States.43
40See Office of Management
Section
13, Identifying
Long
and Budget,
Term
41 We refer to the 1991 Deposit
Budget
Obligations
Insurance
Reform
rules that classify
banks into one of three categories
The rules restrict
the acquisition
of brokered
classified in the lower two categories.
in a limited fashion.
42For further
Merton,
activities
(1992),
the asset
accounting
currently
and Pozdena
mix of Danish
Act.
deposits
In May 1992, FDIC
and the interest
for 1993,
Risks.
adopted
risk-based
see the Appendix
new
ratios.
rates paid by banks
insurance
premiums
to this paper,
Bernard,
banks may lend itself to more effective
mark-to-
(1992).
than for the wider and more complex
undertaken
Government
Underwriting
baaed on their capital-to-asset
also adopted
details about the Danish system,
and Palepu
43Moreover,
market
FDIC
of the U.S.
and Reducing
by U.S. commercial
17
banks.
set of on- and off-balance-sheet
3. Functions
of deposit
insurance
If the collateralization
reform proposed here were implemented, FDIC insurance would cover 100% of transaction deposits but would have little economic
impact,
Treasury
since it would serve only as a backup to collateralization
bills.
Nevertheless,
there is currently
a widespread
with U.S.
belief that
de-
posit insurance is desirable for other reasons. Among those are:
l To encourage
and enhance a safe and convenient form of investment
for
small savers.
l To ensure an adequate
and stable supply of credit to worthy borrowers who
would not otherwise have access to the nation’s supply of capital.
l To facilitate
the creation of liquidity.
l To prevent
a run on the banking
system that
might
destabilize the
macroeconomy.
l To enhance
the efficiency of the payments system.
We believe that only the last of the five requires deposit insurance for efficiency. The other four are better served by alternative means. We offer a
brief analysis of each below.
3.1 Insurance
of savings
deposits
While politically popular, it is not clear that government insurance of savings accounts really adds to social value in today’s financial environment in
the United States. For households who demand completely default-free instruments, there are many other types of assets available in very convenient
forms. Shares in a U.S. Treasury money-market
fund are one example. Indeed, one of the great financial transformations
of the last 20 years has been
the growth of money-market funds and their displacement of depository institutions as the repository of the liquid assets of households.
We suspect that the popularity of government-insured
savings deposits
stems from the belief that somehow insured depositors are getting a bargain.
Given the competition that exists in this sector, it is hard to imagine that this
is the case, unless somehow the existence of government deposit insurance
has created a subsidy to insured depositors.
A threat to the stability and
efficiency of the financial system is the fostering of the illusion that there is a
“free lunch” to be had through the mechanism of fractional-reserve
banking
and FDIC insurance. Safety and liquidity of asset holdings carry a price, and
we see no reason for individuals desiring those features not to pay that price.
If public policy is to subsidize those services for the poor, deposit insurance
is not the least-cost way of doing it.
A common objection
to proposals like the one presented here is that
demand deposits collateralized
by Treasury bills would by necessity offer a
lower promised interest rate than that available on uninsured money-market
18
funds. As the story goes, since money-market funds appear to be as safe and
offer checking privileges, households will use them as transaction
accounts.
The government will then be forced to guarantee them de facto.
Because
the assets of these funds are not as restricted as those permitted in our
transaction-deposit
accounts, these funds would have an unfair advantage.
We do not suggest forbidding mutual funds from offering check-writing
privileges.
If a customer has shares in a mutual fund, it is a great convenience to be able to use a check to order the sale of enough shares to make a
payment for some good or service. There is no need to prevent that, as long
as these mutual funds are marking the value of their assets to market. We
do, however, think that it is desirable to prevent money-market
funds from
creating the illusion of perfect liquidity and complete safety of principal by
keeping a fixed price per share. This practice, which is now very common,
creates the illusion that the funds are offering an asset that is as risk-free and
as liquid as insured demand deposits, but at a higher yield. We see no purpose for the practice of keeping the price per share fixed except to foster such
an illusion.44 Moreover, the assets of these funds, such as Al/PI-rated
commercial paper, are far less risky and opaque than the corporate, commercial
real-estate and sovereign loans that are the core assets of commercial banks.
Hence, by comparison to the status quo, proliferation of such substitutes for
truly default-free deposits is not a major problem.
3.2 Insuring
an adequate
supply
of funds
to small
borrowers
There is a concern that without commercial banks which have access to
government deposit insurance, there would not be enough credit flowing to
households and nonfinancial businesses that do not have direct access to the
capital markets.
Whether there was ever any merit to this argument, we
believe that in the current economic environment in the United States, there
is no longer any. The development of markets for “junk” bonds, securitized
loans (mortgages, automobile loans, trade receivables, etc.), and the growth
of nondepository
finance companies
now provide alternative
sources of credit
to all sectors of the economy.
There is every reason to believe that in a
relatively short period of time, these alternatives
could completely replace
insured deposits as a financing source. Indeed, the loan and credit-evaluation
facilities that currently reside in banks could continue intact with a new
financing facility that does not use deposits. Some commercial banks, such
as J.P. Morgan and Bankers Trust, do not rely on insured deposits as a major
financing source. And, as already noted, the current trend in the commercial
44Alternatively, funds that call themselves “money market” and post a fixed ($1.00)
price per share could be greatly restricted as to the assets they can hold. An example
is the recent
than top-rated
SEC
restriction
of such funds against
(Al/PI).
19
holding
commercial
paper
that
is less
banking industry is that banks are shifting their assets more and more into
marketable debt instruments that are much more liquid than the bank loans
of the past. As an example of just how rapidly the U.S. financial system can
shift the flow of funds from one institutional mechanism to another, consider
the change in the system of housing finance during the past fifteen years.45
None of these new institutional
arrangements
requires government deposit
insurance.
3.3 Facilitating
transformation
services:
generalized
liquidity creation
Diamond and Dybvig (1986) identify transformation
services as one of the
three functions of banks. They oppose policy moves toward 100% reserve
banking because it “... would prevent banks from fulfilling their primary function of creating liquidity” (p. 57). It should be noted, however, that transformation services are performed and liquidity enhanced whenever a collection
of assets is “repackaged” and the resulting liabilities created have a smaller
bid-ask spread than the original assets. Thus, banks that hold illiquid corporate, commercial real-estate,
and sovereign loans as assets and finance their
portfolios by issuing term-debt and equity which are traded in markets are
providing transformation
services and adding to liquidity. Financing such assets by issuing demand deposits is not the only means for increasing general
liquidity in the economy.
Conversely, banks that provide the specialized transformation
service of
increasing the supply
demand deposits need
large bid-ask spreads.
for some economies of
services, historically.
of (nearly) perfectly liquid assets by issuing insured
not invest the proceeds in highly illiquid assets with
Gorton and Pennacchi (1990, 1992a) make a case
scope in jointly producing credit and perfect-liquidity
However, they go on to provide theoretical
analysis
and empirical evidence that such synergistic benefits no longer exist because
of technological
progress and the associated development of new markets
and institutions.
They also describe the asset characteristics
for transformation
into perfectly-liquid
demand deposits:
diversified
portfolio
of (nearly)
have short maturities.
These
riskless
assets
which are best
namely, a well-
which are easy to value and
asset characteristics
fit the profile of money-
market mutual funds, which Gorton and Pennacchi see as far more suited for
supporting transactions
liquidity than the typical bank portfolio.
We agree with the broad points of their analysis, but we go even farther.
Demand deposits are both liquid and riskless.
Liquidity and price uncertainty are logically distinct properties of assets. A perfectly-liquid
security
45As in the case of housing,
an important
the article,
alternative
“Pension
pension funds that have little need for liquidity may become
source of financing
Funds as Yeast
for traditional
for Rising Companies,”
April 21, 1992, p. A17.
20
bank assets.
in the
See, for example,
Wall Skeet
Journal,
trades
with a zero bid-ask
spread.
Thus,
shares of stock traded on securi-
ties exchanges
temporal
can be highly liquid yet have considerable uncertainty about
changes in price. 46 On the other hand, an individual’s claim to a
government pension may be completely riskless with no price uncertainty,
yet be totally illiquid. Government insurance is thus neither necessary nor
sufficient to ensure liquidity.
Under the current system of FDIC
insurance,
the government
guarantees
both the temporal certainty of price and liquidity. However, the bank assets
that traditionally
serve as collateral are both illiquid and subject to considerable price-change uncertainty. This combination makes it very difficult for
the government guarantor to distinguish whether the “low” price obtainable
from an immediate
liquidation
of those collateral
assets is due primarily
to
illiquidity or to a change in their fundamental or intrinsic value.
Perhaps this structure was efficient in the past. However, the current
environment of low and secularly declining transaction costs for securitization
supports a hierarchical or “incremental”
approach as an efficient means for
providing liquidity. Thus, highly illiquid and opaque assets can be financed
with stocks, bonds, and short-term debt instruments.47
Portfolios of those
securities,
in turn, can be used to collateralize
other claims having even
greater liquidity. To create securities with minimal price uncertainty, senior
short-term fixed-income claims could be issued against a portfolio of liquid
assets which serve as collateral.
The value of those liquid collateral assets
would have to be much larger than the promised principal on the fixed-income
claims, so that promised payments could still be met even with large price
declines on the collateral assets.4s
This hierarchical approach uses the “next-nearest”
asset for transformation to support perfectly-liquid
and safe demand deposits.
Thus, as advocated at the outset, the asset collateral ideally should be U.S. Treasury
bills. If the demand for highly liquid, riskless transaction
deposits exceeds
T
reasury bills, then add a well-diversified
portfolio of
the supply of U.S.
traded short-term,
cial paper.4g
high-grade
corporate
debt such as Al/Pi-rated
commer-
46By price in this context we mean the full price realizable from an orderly unrushed
sale of the stock.
47Ultimately
the economic uncertainties
associated with illiquid assets have to be borne
by someone. But the form in which they are borne can be made more liquid.
4”This approach differs from just having a large capital requirement on banks with their
current configuration
of assets and liabilities because the assets here are liquid.
4gAs of December 1991, there were $590.4 billion of U.S. Treasury bills outstanding,
and
the total of all interest-bearing
marketable
U.S. Treasury debt was $2,471.6 billion. The
approximate
size of the U.S. commercial-paper
market is $530.3 billion. Demand deposits
at commercial
banks were $289.5 billion, and checkable deposits at other depository
institutions
$333.2 billion. Source: Federal Reserve Bnllelin, July 1992, Tables 1.21, 1.32,
1.41.
21
3.4 Preventing
runs
The worst-case scenario is a banking panic. Depositors are content to leave
their deposits in banks as long as they are confident that their money is safe
and accessible.
However, depositors
know that the bank is holding illiquid
and risky assets as collateral for its obligation to depositors. If they believe
that they will not be able to get back the full value of their deposits, then
depositors will race to be first in line to withdraw their money. This forces
the bank into liquidating some of its risky assets. If the collateral assets are
illiquid, then being forced to liquidate them quickly means that the bank
will have to accept less than full value for them. If one bank does not have
sufficient funds to pay off its depositors, then “contagion” can set in, and
other banks are faced with a run. However, such a contagion problem occurs
for the banking system as a whole only if there is a flight to currency.50
The root cause of banking pa.nics is therefore the financing of illiquid bank
loans with demand deposits. 5* Government deposit insurance is very potent
medicine to solve the problem of bank runs. While it seems to work, deposit
insurance as a cure for banking panics has major drawbacks. It requires the
government to distinguish between “good” loans that a.re illiquid but will
pay off in full and “bad” loans that will not. Essentially, all the models that
show the welfare gains from eliminating panics (cf. Diamond and Dybvig,
1983) assume away this problem by positing that it is known for certain that
illiquid bank assets will realize their full promised value if only they are held
to maturity.
In the real world, the benefits of eliminating panics must be
traded off against the prospect that the “true” economic value of the assets
is below the promised value of deposits (i.e., the panic is “justified”) and the
government is providing a “windfall” bailout. Surely, the opaque and illiquid
assets held by commercial banks a.re a particularly difficult group in making
that assessment. Hence, the case for welfare benefits from preventing runs is
greatly diluted if the insured institution holds assets of this type.52 Much the
same issue arises when the government intervenes by providing temporary
liquidity through the Federal Reserve discount window. The collateralizeddeposit proposal of this paper solves this problem by stopping the financing
of opaque, illiquid loans with insured demand deposits.
“The
improbability
one that
Meltzer
existed
(1967)
and
51 For a discussion
(1991).
52Gorton
banks
and
providing
of a flight
in the 1930s
Tobin
and
(1987,
of the history
Pennacchi
banking
(1992b)
to currency
distinguishes
contributed
to the severity
pp.
the current
of the Great
situation
from
Depression.
the
(cf.
168-9)).
of panics
in the United
fi n d no empirical
services.
22
States,
evidence
see Calomiris
of contagion
and Gorton
effects
for non-
3.5 Enhancing
the eficiency
of the payments
system
As stated at the outset of this paper, the function of a payments
system is to
facilitate the efficient exchange of goods and services. In the United States,
checks and wire transfers drawn on commercial banks are an important means
of payment.
For large transactions,
the seller will often call the bank in
advance to verify that the buyer has sufficient funds in his account to cover
the check. Sometimes, for smaller transactions,
there are insufficient funds
in the check-writer’s
account. The resultant “bad” checks are a nuisance to
those who receive them and, if it is unintentional,
to those who write them.
This system of making payments is nevertheless quite efficient because
sellers do not have to spend much time or effort verifying information about
the credit-worthiness
of buyers, and buyers do not have to spend much time
or effort proving their credit-worthiness
to sellers. Both parties rely on the
bank to perform this verification and to guarantee payments up to the amount
in the buyer’s demand-deposit
account. But what if the solvency of the bank
of this
itself is in question ? Then a large part of the information-efficiency
system is lost.
To understand the efficiency gains from Federal insurance of transactions deposits, it is helpful to draw a distinction between the “customers”
and the “investors” of a commercial bank that provides demand deposits.53
Customers who hold the bank’s demand-deposit
liabilities are identified by
their strict preference to have the payoffs on their deposits as insensitive as
possible to the fortunes of the bank itself.54 By contrast, investors in the
liabilities (e.g., stocks or bonds) issued by the bank expect their returns to
be affected by the bank’s profits and losses. Indeed, the primary function of
the investors is to provide the risk capital which protects depositors against
default risk stemming from a mismatch between the bank’s assets and its
deposit liabilities.
The investors are of course compensated for this service
by an appropriate expected return. Note that while the roles of “customers”
and “investors” are distinct, the same individual can be both a customer of
and an investor in a particular banking firm. Thus, we can be both a depositor at a particular bank and also hold shares of its common stock as part of
our investment portfolio.55
53For a more complete discussion of the distinction between the “customers” and the
“investors” of a financial intermediary, see Merton and Bodie (1992b,c).
54As a formal
example
of this general
point, consider
an economy
where there are pure
Arrow-Debreu
securities for every state of the world. It is well-known that a complete
set of such securities permits Pareto-efficient
allocations.
If, however, the payoffs on such
securities
were also contingent
would lose their efficiency.
discussion
“By
on the solvency
See Merton
of the issuer of the securities,
(1992a,
pp.
450-1,
463~7)
for a more
then they
complete
of this point.
definition,
also investors.
mutual
However,
banks are organized
t,he depositors
in such a way that all of their depositors
of mutual
23
banks are probably
unaware
are
that, they
If demand deposits are subject to default risk on the part of the bank,
then sellers of goods seeking to verify the ability of buyers to make good on
their promises to pay would have to verify not only that the buyer has enough
money in his account
solvent.
Similarly,
but also that the bank in which the account
buyers who want the convenience
of writing
is held is
default-free
checks would have to monitor the solvency of the bank in which they have
their account.
Uncertainty about the ability of the bank to make good on
its deposit liabilities
thus creates
“deadweight”
losses.
The system of collateralized demand deposits that we advocate eliminates
this deadweight loss for all parties at minimal cost.56 The role of the FDIC
in this system is simply to confirm to the public that sufficient collateral is
there and that if it is not, then the FDIC will make good on the payment.
4. Conclusions
We are certainly not the first to arrive at our proposed solution to the depositinsurance problem in the United States. 57 However, we harbor the hope that
we have strengthened the ca.se for this solution by setting forth familiar a.rguments in a somewhat different way that perhaps highlights certain critical
issues. These are:
l There
is a continuing need for the government to serve as the ultimate
insurer of the payments system. We believe that the least-cost method for
doing so is to restrict FDIC coverage to deposits that are backed 100% by
the shortest-term
U.S. Treasury securities.
l If, contrary
to our beliefs, one concludes that there is great value in preserving the current institutional
structure of banks, there are other ways
Deposits that are collateralized
by more
to improve the current system.
volatile
assets can be guaranteed through a combination of monitoring and
The collateral assets used for this purpose must be
risk-based premiums.
marked to market at their bid price, and capital standards must be strictly
enforced. However, these alternatives to the proposal of 100% U.S. Treasurybacked deposits are more costly.
l A threat
to the stability and efficiency of the financial system is the fostering of the illusion that liquid and riskless deposits can be used to finance
are also investors. Indeed, if they believed that they were exposed to meaningful default
risk by virtue of holding their deposits at a mutual bank, they would probably hold their
transactions
balances elsewhere.
56Gorton and Pennacchi (1992a) point out that deposits can be made riskless either by
the government guaranteeing
the deposits’ value or by “guaranteeing”
the asset value by
requiring the banks to hold U.S. Treasury bills. The latter way avoids the problem of
unintended
transfers of wealth caused by mispriced deposit insurance.
57We echo the view of our good friend, Stanley Fischer, M.I.T., that in matters of public
policy, he would rather be right than original.
24
illiquid and risky assets at a small cost. The mechanism believed to provide
this “free lunch” is traditional fractional-reserve
banking and FDIC insurance.
Belief in this illusion may explain the widespread
popular
support for
insurance of savings deposits. Safety and liquidity of asset holdings carry a
price, and if individuals demand these features, they should pay that price.
If public policy is to subsidize those services for the poor, deposit insurance
is not the least-cost way of doing it.
l Although
there may have been at one time synergies
from using insured
deposits as the primary means to finance the commercial
lending activities
banks, there no longer
institution that takes
other financial-service
With deposits backed
of
are. There may be efficiency gains in having the same
deposits also engage in making loans and performing
activities.
Our proposed reforms do not rule this out.
100% by U.S. Treasury securities held in a custodial
account at the Federal Reserve, there is no danger that the security of those
deposits would be jeopardized by other activities of the depository institution. Thus, under this proposal there is no need to have rules or laws (such
as the Glass-Steagall
Act of 1933) restricting the other financial activities of
depository institutions.
We close with a few words about the feasibility of implementing our proposal. The two functions traditionally
performed by U.S. commercial banks
are increasingly
being taken over by other financial intermediaries.
Some
competitors, such as finance companies, compete with banks in making loans
without using deposits as a source of financing. Junk bonds have replaced
some bank loans. Further innovations currently under way suggest that pension funds may also serve as an alternative source for traditional bank-loan
customers. Indeed, as noted, even some commercial banks, such as J.P. Morgan and Bankers Trust, do not rely on insured deposits as their principal
funding source. Thus, as with the major changes in the sources of funding
for housing during the 1980s) we see no major economic problem in shifting
the financing of bank assets to nondeposit
may, of course, be a political problem.
With
respect
to the deposit-taking
sources during the 1990s.
function
of banks,
institutions
There
such
as money-market
funds compete with banks in providing safe and liquid
assets in a convenient form. In effect, money-market
funds offer deposits
backed 100% with collateral that is not opaque and illiquid. U.S. Treasurybill money-market
funds are close to the institutional structure for the transactions deposits proposed here. Thus, implementation
of our proposal is
feasible. The short-run transition costs for this proposal may exceed those
of some alternatives.
However, as we have indicated, there are other intermediate and long-run costs of choosing those alternatives.
Hence, including
the present value of those longer-run cost differences, we believe that our
proposal is efficient.
25
Under our proposal, the successor institutions to commercial banks are
likely to evolve from those banks. They will keep the same employees for
credit analysis and loan origination, and many will retain the same corporate
identity. 58 Banks
with special expertise
in originating
and servicing
corpo-
rate, commercial real-estate, and sovereign loans would continue to perform
those activities.
The financing of those activities, however, would not come
from insured deposits. Large banks would expand their fund-raising through
issuing debt and equity securities.
Smaller banks without direct access to
the capital
markets
could arrange financing
through
syndication
with insti-
tutions that have such access. A number may find that the best solution is
to merge with other institutions.
Given the extraordinarily
high operating
expenses of the U.S. banking industry today, many observers agree that consolidation is necessary to reduce those costs and improve efficiency.5g Our
proposal would thus facilitate that consolidation.
However, the greatest potential efficiency gains from reforming deposit
insurance along the lines proposed here may well be the gains from reduced
regulation. While the successor institutions to commercial banks would still
have to comply with securities laws and other regulations that apply to all
financial-service
firms, they would be free of the extra regulatory burdens
currently imposed on banks as a quid pro quo for deposit insurance and
special treatment by the Federal Reserve.”
5sFor
out
this
example,
century
Citibank
even
span.
5gMuch the same
601n an editorial,
L.J.
White
protected
Costs.”
refers
them
it has
essentially
performed
quite
the same
corporate
identity
different
functions
during
transition
is taking
place in the thrift industry.
“Don’t Handcuff
the Healthy
Banks,”
New York
to this
but
has maintained
though
also
quid pro quo with
subjected
them
the banks
to regulated
26
as “...the
public
Times,
Faustian
utility
May
bargain
treatment
throughthat
time
17, 1992,
that
and
has
extra
Appendix:
The
Danish
System’
Denmark has used a mark-to-market
accounting system combined with
strictly enforced capital requirements for banks for many years. While one
in eight Danish banks has failed within the last five years, all but one of the
failures were handled without explicit government financial assistance.
If a bank in Denmark
falls below the required
8% capital
ratio at the
end of any quarter, the government regulatory agency (the Danish Financial
Supervisory Authority)
allows six months for the institution
to raise new
capital (including equity and up to 40% subordinated debt). If, at the end
of six months, the bank is still not in compliance,
the regulatory agency
immediately
places the bank under new control, generally by arranging an
acquisition by a healthy bank. If an acquirer cannot be found, the bank is
closed.
Prior to 1988, Denmark had no formal deposit-insurance
system. However, when the C&G Banken bank failed in 1987 and was closed, the Danish
government covered the resulting deficit to depositors (about $50 million).
Since that time, a deposit-insurance
system has been established.
However,
although the regulatory a.uthority has intervened in 23 cases of capital deficiencies,
there has not been one where government
‘See Bernard,
Merton,
and Palepu
(1992)
27
and Pozdena
assistance
(1992)
was required.
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