Deposit Insurance and Other
Liability Guarantees
Chapter 19
Financial Institutions Management, 3/e
By Anthony Saunders
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Background issues and History
• Bank runs can serve a useful purpose
» Contagion has more serious consequences
• FDIC created 1933
• Securities Investors Protection Corporation
(SIPC) 1970.
• Pension Benefit Guaranty Corporation (PBGC)
created 1974.
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FDIC

FDIC created in wake of banking panics.
• 10,000 failed commercial banks.
• Original coverage: $2,500. Now $100,000.
• Between1945-1980: FDIC worked. Failures
accelerated in 1980.
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FDIC (continued)
• In 1991: Borrowed $30 billion from Treasury
and still generated a $7 billion deficit.
• FDIC Improvement Act 1991.
• The funds’ reserves now stand at a record high
with reserves exceeding 1.4% of insured
deposits.
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FSLIC
• FSLIC covered S&Ls. Other thrifts often chose
FDIC coverage.
• High levels of failed thrifts between 1980-88
generated losses of $78 billion. From 1989-92
additional 734 failures . Cost: $78 billion.
• Result: FSLIC estimated net worth negative
$40 to $80 billion.
• Policy of forebearance.
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Demise of FSLIC
• Forebearance consequences:
» Accumulation of greater losses.
• Financial Institutions Reform, Recovery and
Enforcement Act, (FIRREA) 1989.
» Management transferred to FDIC.
» Savings bank insurance fund became Savings Association
Insurance Fund (SAIF). Managed separately from Bank
Insurance Fund (BIF).
• Resolution Trust Corporation (ended 1995)
» $90.1 billion
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Causes of depository fund
insolvency

Financial Environment:
• Rise in interest rates.
• Collapse in oil, real estate and commodity
prices.
• Increased competition.
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Depository Fund Insolvency
(continued)

Moral Hazard:
• Deposit insurance encouraged underpricing of
risk and reduced depositor discipline.
• Premiums not linked to risk.
• Inadequate monitoring.
• Prompt Corrective Action (1992).
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Trade-off between moral hazard and
bank run risk
• Insurance was not actuarially fairly priced.
» Reduced incentive for runs.
» Increased moral hazard.
M
Run Risk (R)
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Controlling Bank Risk Taking
• Stockholder discipline
» Practical problems in applying option pricing to
insurance premiums
» FDIC adopted risk-based premiums 1993
» Based on: categories and concentrations of assets &
liabilities; other factors that affect probability of
loss; deposit insurer’s revenue needs.
» Increased capital requirements, stricter closure rules,
prompt corrective action.
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Controlling bank risk taking
• Depositor discipline
» Insurance cap can be increased by altering structure
of deposit funds and by spreading deposits across
banks. Higher interest rates provided incentive to
deposit in riskier banks -up to coverage limit.
» Limits on brokered deposits.
» Implicit 100% coverage resulted from too big to fail.
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Failure resolution pre-FDICIA
• Liquidation (payoff) method unless alternative
judged to cost less.
• 1993 Depositor Protection Legislation
» gave lower priority to foreign uninsured depositors
and creditors supplying federal funds on the
interbank market.
• Purchase and assumption method.
• Open Assistance. FDIC loans or capital funds
to keep large failing bank open.
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Failure resolution post-FDICIA

January 1995 FDICIA required least-cost
resolution.
• Systemic risk exception.
• Insured depositor transfer (IDT) or “haircut”
method encourages depositor vigilance.
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Regulatory discipline

Perception of 2 weaknesses in regulatory
practices:
• Frequency and thoroughness of examinations
• Forebearance shown to weakly capitalized banks
pre-1991.
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Regulatory discipline (continued)

Capital forebearance:
• Prompt Corrective Action. Transition to rules
rather than discretion.

Examinations:
• improved accounting standards including
market valuation of assets and liabilities; annual
on-site examination of every bank.
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Non-U.S. deposit insurance
EC proposed single deposit insurance
system to be introduced at end of 1999.
 Co-insurance through deductibles.

• Currently, deductibles vary across countries.
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Discount Window
• Central bank as lender of last resort through
discount window. Short-term, non-permanent.
• Requires high-quality liquid assets as collateral.
• “Need to borrow basis”.
• Not permanent support for unsound banks.
• Loans to troubled banks limited to no more than
60 days in any 120 day period unless authorized
by FDIC and institution’s primary regulator.
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Other Guaranty Programs
• PC and Life Insurance Companies regulated at
state level. No federal guaranty fund.
• State guaranty funds run and administered by
the private insurance companies themselves.
• Only NY has permanent guaranty fund for PC
and life insurance.
• Definition of small policyholder varies across
states from $100,000 to $500,000.
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Other Guaranty Programs
• Often delays in settling claims against
insurance companies.

Securities Investor Protection Corporation:
• Pro rata shares of liquidated assets. SIPC
covers remaining claims up to $500,000 per
individual.
• SIPC losses have been small but concern has
increased.
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Pension Benefit Guaranty Corp.
• PBGC established in 1974 under Employee
Retirement Income Security Act (ERISA).
• PBGC experienced deficit of $2.7 billion at end
of 1992. Unlike FDIC, it has no monitoring
power over insured pension plans.
• 1994 Retirement Protection Act phases out
premium cap. Deficit expected to be eliminated
within 10 years.
» Risk-based premium scheme.
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