Bank Management, 5th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning
THE EFFECTIVE
USE OF CAPITAL
Chapter 13
Why worry about bank capital?
…capital reduces the risk of failure by acting as a
cushion against losses and by providing access to
financial markets to meet liquidity needs.
 While bank capital-to-asset ratios averaged near 20% at the turn
of the century, comparable ratios today are closer to 8 percent.
15.00%
Historical Trends in Bank Capital
13.00%
11.00%
9.00%
7.00%
5.00%
3.00%
1.00%
-1.00%
Total Capital to Total Assets
Growth Rate in Total Capital
Risk-based capital standards
 During the last half of the 1980s, for example,
all U.S. banks were required to meet a 5.5%
minimum primary capital requirement and a 6
percent minimum total capital requirement.
 Primary capital consisted of stockholders
equity, perpetual preferred stock, mandatory
convertible debt, and loan loss reserves.
The Basle agreement
 In 1986, U.S. bank regulators proposed that
U.S. banks be required to maintain capital that
reflects the riskiness of bank assets.
 By 1988, the proposal had grown to include
risk-based capital standards for banks in 12
industrialized nations according to the terms
of the Basle Agreement.
 Regulations were fully in place by the end of
1992.
Terms of the Basle Agreement varied,
primarily in terms of what constitutes
capital, but there are common elements.
 Minimum capital requirement is linked to its
credit risk as determined by the composition
of assets.
 Stockholders' equity is deemed to be the most
critical type of capital.
 Minimum capital requirement increased to 8%
for total capital.
 Capital requirements were approximately
standardized between countries to 'Level the
playing field.'
Risk-based elements of the plan
 To determine minimum capital requirements,
bank managers follow a four-step process:
1.
2.
3.
4.
Classify assets into one of four risk
categories;
Classify off-balance sheet commitments and
guarantees into the appropriate risk
categories;
Multiply the dollar amount of assets in each
risk category by the appropriate risk weight;
this equals risk-weighted assets; and
Multiply risk-weighted assets by the minimum
capital percentages, currently either 4 percent
or 8 percent.
Regional National Bank (RNB), risk-based
capital
Regional National Bank (RNB)
Assets
$ 1,000
Category 1: Zero Percent
Cash & reserve
Trading Account
U.S. Treasury & agency secs.
Federal Reserve stock
Total category 1
Category 2: 20 percent
Due form banks / in process
Int. bearing Dep./F.F.S.
Domestic dep. institutions
Repurchase agrements (U.S. Treas & agency)
U.S. Agencies (gov. sponsored)
State & Muni's secured tax auth
C.M.O. backed by agency secs.
SBAs (govt. guaranteed portion)
Other category 2 assets
Total category 2
Category 3: 50 percent
C.M.O. backed by mtge loans
State & Muni's / all other
Real estate: 1-4 family
Other category 3 assets
Total category 3
Risk
Weight
Risk
Weighted
Assets
104,525
830
45,882
5,916
157,153
0.00%
0.00%
0.00%
0.00%
0
0
0
0
0
303,610
497,623
38,171
329,309
412,100
87,515
90,020
29,266
0
1,787,614
20.00%
20.00%
20.00%
20.00%
20.00%
20.00%
20.00%
20.00%
20.00%
60,722
99,525
7,634
65,862
82,420
17,503
18,004
5,853
0
357,523
10,000
68,514
324,422
0
402,936
50.00%
50.00%
50.00%
50.00%
5,000
34,257
162,211
0
201,468
Regional National Bank (RNB)
Risk-based capital
Regional National Bank (RNB), Risk-Based Capital
Assets
$ 1,000
Category 4: 100 percent
Loans: comm/ag/inst/leases
Real estate, all other
Allowance for loan and lease losses
Other investments
Premises, eq. other assets
Other category 4 assets
Total category 4
Total Assets before Off-Balance Sheet
Off-Balance Sheet Contingencies
0% collateral category
20% collateral category
50% collateral category
100% collateral category
Total Contingencies
Total Assets and Contingencies before
allowance for
Less: Excess allowance for loan and lease losses
(amount that exceeds 1.25% of gross RAA)
Total Assets and Contingencies
1,966,276
388,456
(70,505)
168,519
194,400
0
2,647,146
Risk
Weight
100.00%
100.00%
0.00%
100.00%
100.00%
100.00%
4,994,849
0
0
364,920
290,905
655,825
5,650,674
Risk
Weighted
1,966,276
388,456
0
168,519
194,400
0
2,717,651
3,276,642
0.00%
20.00%
50.00%
100.00%
0
0
182,460
290,905
473,365
3,750,007
(2,152)
5,650,674
3,747,855
Regional National Bank (RNB)
Risk-based capital (continued)
Regional National Bank (RNB)
Off Balance Sheet Conversions
Contingencies 100% conversion factor
Direct Credit substitues
Acquisition of participations in BA, direct
Assets sold w/ recourse
Futures & forward contracts
Interest rate swaps
Other 100% collateral category
Total 100% collateral category
Contingencies 50% conversion factor
Transaction-related contingencies
Unused commitments > 1 year
Revolving underwriting facilities (RUFs)
Other 50% collateral category
Total 50% collateral category
Contingencies 20% conversion factor
Short-term trade-related contingencies
Other 20% collateral category
Total 20% collateral category
Contingencies 0% conversion factor
Loan commitments < 1 year
Other 0% collateral category
Total 0% collateral category
1999
Assets
$ 1,000
$ Amt.
Risk
Weight
Risk
Weighted
Assets
Credit
Credit
165,905
0
0
50,000
75,000
0
290,905
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
165,905
0
0
50,000
75,000
0
290,905
0
364,920
0
0
364,920
50.00%
50.00%
50.00%
50.00%
0
182,460
0
0
182,460
0
0
0
20.00%
20.00%
0
0
0
0
0
0
0.00%
100.00%
0
0
0
General descriptions of the four risk
categories
Asset
Category
Risk
Weight
Effective
Total Capital
Requirement
1
0%
0%
2
20%
1.6%
3
50%
4%
4
100%
8%
Obligor, Collateral, or Guarantor of the Asset
Generally, direct obligations of the federal
government; e.g., currency and coin, government
securities, and unconditional government
guaranteed claims. Also balances due or
guaranteed by depository institutions.
Generally, indirect obligations of the federal
government; e.g.; most federal agency securities,
full faith and credit municipal securities, and
domestic depository institutions. Also assets
collaterlized by federal government obligations
are generally included in this category; e.g.,
repurchase agreements (when Treasuries serve as
collateral) and CMOs backed by government
agency securities.
Generally, loans secured by one to four family
properties and municipal bonds secured by
revenues of a specific project (revenue bonds).
All other claims on private borrowers.
What constitutes bank capital?
…according to accounting definition, capital or
net worth equals the cumulative value of assets
minus the cumulative value of liabilities, and
represents ownership interest in a firm.
 Total equity capital equals the sum of:
 common stock,
 surplus,
 undivided profits and capital reserves, and
 net unrealized holding gains (losses) on
available-for-sale securities and cumulative
foreign currency translation adjustments, and
 perpetual preferred stock
Risk-based capital standards
…two measures of qualifying bank capital
1. Tier 1 or core capital consists of (4%):
 common equity,
 qualifying perpetual preferred stock, and
 minority interest in consolidated subsidiaries,
less intangible assets such as goodwill.
2. Tier 2 capital or supplementary capital:
 allowance for loan loss reserves up to 1.25
percent of risk-weighted assets,
 preferred stock, and
 mandatory convertible debt.
Leverage capital ratios
 Regulators are also concerned that a bank
could acquire so many low-risk assets that
risk-based capital requirements would be
negligible

hence, regulators have also imposed a 3
percent leverage capital ratio, defined as:

Tier 1 capital divided by total assets net of
goodwill and disallowed intangible assets and
deferred tax assets.
 This capital requirement was implemented to
prevent banks from operating with little or no
capital, even though risk-based standards
might allow it.
Risk-based capital ratios for differentsized U.S. Commercial banks
Asset Size
Number of Institutions Reporting
Equity capital ratio (%)
Return on equity (%)
Core capital (leverage) ratio (%)
Tier 1 risk-based capital ratio (%)
Total risk-based capital ratio (%)
Year
2001
2000
1999
1997
1995
2001
2000
1999
1997
1995
2001
2001
2001
2001
$100
Million
to $1
< $100
Million Billion
4,486
3,194
4,842
3,078
5,156
3,030
5,853
2,922
6,658
2,861
10.9
9.68
11.08
9.6
10.68
9.24
10.81
9.62
10.42
9.39
8.07
12.24
10.63
9.17
15.87
12.88
16.96
14.06
$1 to
$10
Billion
320
313
318
301
346
9.76
8.99
9.09
9.16
8.57
13.77
8.74
11.83
13.77
> $10
Billion
80
82
76
66
75
8.77
8.05
7.87
7.58
7.19
13.43
7.23
8.86
12.16
All
Commercial
Banks
8,080
8,315
8,580
9,142
9,940
9.09
8.49
8.37
8.33
8.11
13.1
7.79
9.9
12.72
FDICIA and bank capital standards
 Effective December 1991, Congress passed the
Federal Deposit Insurance Improvement Act
(FDICIA) with the intent of revising bank capital
requirements to:



emphasize the importance of capital and
authorize early regulatory intervention in
problem institutions, and
authorized regulators to measure interest rate
risk at banks and require additional capital
when it is deemed excessive.
 A focal point of the Act was the system of
prompt regulatory action, which divides banks
into categories or zones according to their
capital positions and mandates action when
capital minimums are not met.
Five capital categories of FDICIA.
 Not subject to regulatory directives regarding
capital:
1.
2.
well-capitalized and
adequately capitalized banks
 Subject to regulatory restrictions:
3. Undercapitalized,
4. significantly undercapitalized and
5. critically undercapitalized
Capital categories under FDICA
Total RiskBased Ratio
Tier 1 RiskBased Ratio
Well capitalized
10%
&
6%
&
Adequately capitalized
8%
&
4%
&
Undercapitalized
< 8%
or
< 4%
or
Significantly undercapitalized
< 6%
or
< 3%
or
Critically undercapitalized
Tier 1
Capital Directive / Requirement
Leverage
Ratio
Not subject to a capital
directive to meet a specific level
5%
for any capital measure
Does not meet the definition of
4%
well capitalized
< 4%
< 3%
Ratio of tangible equity to total assets is  2%
Prompt regulatory action under
FDICIA
B.
Provisions for Prompt Corrective Action
Category
Well capitalized
Adequately capitalized
Undercapitalized
Significantly
undercapitalized
Critically undercapitalized
Mandatory Provisions
Discretionary Provisions
None
None
1. No brokered deposits, except with
FDIC approval
1. Suspend dividends and management
fees
2 Require capital restoration plan
3. Restrict asset growth
4. Approval required for acquisitions,
branching, and new activities
5. No brokered deposits
1. Same as for Category 3
2. Order recapitalization
3. Restrict interaffiliate transaction
4. Restrict deposit interest rates
5. Pay of officers restricted
None
1. Same as for Category 4
2. Receiver/conservator
within 90
daysd
3. Receiver if still in Category 5 four
quarters after becoming critically
undercapitalized
4. Suspend
payments on subordinated
debtd
5. Restrict certain other activities
Order recapitalization
2. Restrict interaffiliate transactions
3. Restrict deposit interest rates
4. Restrict certain other activities
5. Any other action that would better
carry out prompt corrective action
1. Any Zone 3 discretionary actions
2. Conservatorship or receivership if
fails to submit or implement plan or
recapitalize pursuant to order
3. Any other Zone 5 provision, if such
action is necessary to carry out
prompt corrective action
Tier 3 capital requirements for market risk
…many large banks have dramatically increased the size
and activity of their trading accounts, resulting in greater
exposure to market risk.
 Market risk is the risk of loss to the bank from
fluctuations in interest rates, equity prices, foreign
exchange rates, commodity prices, and exposure to
specific risk associated with debt and equity positions
in the bank’s trading portfolio.

Market risk exposure is, therefore, a function of the
volatility of these rates and prices and the
corresponding sensitivity of the bank’s trading assets
and liabilities.
Tier 3 capital requirements for market risk
…In response to the FDICIA stipulation that regulators
systematically measure and monitor a bank’s market risk
position, risk-based capital standards require all banks
with significant market risk to measure their market risk
exposure and hold sufficient capital to mitigate this
exposure.
 A bank is subject to the market risk capital guidelines
…if its consolidated trading activity, defined as the sum of trading
assets and liabilities for the previous quarter, equals 10 percent or
more of the bank’s total assets for the previous quarter, or $1
billion or more in total dollar value.
 Banks subject to the market risk capital guidelines
must maintain an overall minimum 8 percent ratio of
total qualifying capital to risk-weighted assets and
market risk equivalent assets.
 Tier 3 capital allocated for market risk plus Tier 2
capital allocated for market risk are limited to 71.4
percent of a bank’s measure for market risk.
Value-at-risk
 Market risk exposure is a function of the
volatility of rates and prices and the
corresponding sensitivity of the bank's trading
assets and liabilities.
 The largest banks use a value-at-risk (VAR)
based capital charge, estimated by using an
internally generated risk measurement model.
The original Basel Accord’s approach to capital
requirements was primarily based on credit risk.
 Although it set appropriate protections from a
market- and credit-risk perspective, it did not
address operational or other types of risk.
 Operational risk itself is not new to financial
institutions.


It’s the first risk a bank must manage, even
before making its first loan or executing its first
trade.
What is new is that by 2005, a bank’s regulatory
capital needs could increase significantly—up
to 20 percent of total risk-based capital—as a
result of its exposure to operational risk.
The new BASEL capital accord (BASEL II)
and operational risk
 The events of September 11, 2001 tragically
demonstrated the need for banks to protect
themselves against operational risk to their systems
and people.
 Starting in 2005, regulators will begin calculating bank
capital according to the recently adopted Basel II
Accord for capital adequacy.



The new focus of Basel II is operational risk.
The focus is on the optimum use of capital in the
technology and business process operations areas of a
financial institution.
The Basel Committee defines operational risk as
“the risk of loss resulting from inadequate or failed
internal processes, people, and systems, or from
external events.”
Functions of bank capital
 Provides a cushion for firms to absorb losses
and remain solvent.
 Provides ready access to financial markets,
guards against liquidity problems.
 Constrains growth and limits risk-taking:
TA / TA = EQ / EQ
ROA  (1  DR)  EC / TA
TA / TA 
EQ / TA  ROA  (1  DR)
Example:
TA / TA = EQ / EQ
 Assume ROA=1.1%, 7% equity, DR=40%:
0.11 (1  0.4)  0
%TA 
0.07  0.11 (1  0.4)
 10.41%
Weakness of the risk-based capital
standards
 The current formal standards do not account for any
risks other than credit risk, except for market risk at
large banks with extensive trading operations.

Although the new Basel II does account for operational
risk.
 Book value of capital is not the most meaningful
measure of soundness.


It ignores changes in the market value of assets, the
value of unrealized gains or losses on held-to-maturity
bank investments, the value of a bank charter, and the
value of federal deposit insurance.
Trading account securities must be marked-to-market
and unrealized gains and losses reported on the income
statement but other bank assets and liabilities are
generally listed at book value

The contra asset account, Loan Loss Allowance, is a crude
measure of anticipated default losses but does not
generally take into account the change in value of the loans
from changes in interest rates.
The effect of capital requirements on
bank operating policies:
limiting growth
Ratio
Asset growth rate (percent)
Asset size (millions of $)
ROA (percent)a
Dividend payout rate (percent)
Undivided Profits (millions of $)
Total capital less undivide profits (millions of $)
Total capital / total assets (percent)
Case 1
Intitial Initial 8%
Position Asset
Growth
8.00%
100.00
108.00
4.00
4.00
8.00%
Case 2
12%
Growth:
 ROA
12.00%
112.00
Case 3
Case 4
12% 12% Growth:
Growth:  External
 ROA
Capital
12.00%
12.00%
112.00
112.00
0.99% 1.43% 0.99%
40.00% 40.00% 13.42%
4.64
4.96
4.96
4.00
4.00
4.00
8.00% 8.00% 8.00%
0.99%
40.00%
4.665
4.295
8.00%
Application of Equation 13.2
Case 1: 8% asset growth, dividend payout = 40%, and capital ratio = 8%.
What is ROA?
ROA(1  0.40)  0
0.08 
0.08  ROA(1  0.40)
Solve for ROA  0.99%
Case 2: 12% asset growth, dividend payout = 40%, and capital ratio = 8%.
What is required ROA to support the 12% asset growth?
ROA(1  0.40)  0
0.12 
0.08  ROA(1  0.40)
Solve for ROA  1.43%
Case 3: ROA = 0.99%, 12% asset growth, and capital ratio = 8%.
What is the required  dividend payout to support the 12% asset growth?
0.99(1 DR)  0
0.12 
0.08  0.99(1 DR)
Solve for DR  13.42%
Case 4: ROA = 0.99%, 12% asset growth, capital ratio = 8%, and dividend payout =
40%.
What is the required  external capital to support the 12% asset growth?
0.99(1 0.40)  ΔEC/TA
0.12 
0.08  0.99(1 0.40)
Solve for EC/TA  0.29%
ΔEC  $294,720
External capital sources
 Banks that choose to expand more rapidly
must obtain additional capital from external
sources, a capability determined by asset
size.
 Large banks tap the capital markets regularly,
but small banks must pay a stiff premium to
obtain capital, if it is available at all.
 Capital sources can be grouped into one of
four categories:
1.
2.
3.
4.
subordinated debt,
common stock,
preferred stock, or trust preferred stock and
leases.
 Each carries advantages and disadvantages.
Subordinated debt
 Does not qualify as Tier 1 or core capital
 Imposes an interest expense burden on the
bank when earnings are low.
 Subordinated debt offers several advantages
to banks.


interest payments are tax-deductible,
generates additional profits for shareholders as
long as earnings before interest and taxes
exceed interest payments.
 Subordinated debt also has shortcomings.
 interest and principal payments are mandatory,
default if not paid
 many issues require sinking funds
Common stock
 Common stock is preferred by regulators as a
source of external capital.



It has no fixed maturity and thus represents a
permanent source of funds.
Dividend payments are discretionary,
Losses can be charged against equity, not debt,
so common stock better protects the FDIC.
 Common stock is not as attractive from the
bank's perspective due to its high cost
because:


dividends are not tax-deductible,
transactions costs on new issues exceed
comparable costs on debt, and shareholders
are sensitive to earnings dilution and possible
loss of control in ownership.
Preferred stock
 Preferred stock is a form of equity in which
investors' claims are senior to those of
common stockholders.



As with common stock, preferred stock pays
nondeductible dividends
One significant difference is that corporate
investors in preferred stock pay taxes on only
20 percent of dividends.
For this reason, institutional investors dominate
the market.
 Most issues take the form of adjustable-rate
perpetual stock.
Trust preferred stock
 Trust preferred stock is a hybrid form of equity
capital at banks.
 It is attractive because it effectively pays
dividends that are tax deductible.
 To issue the security, a bank establishes a
trust company.




The trust company sells preferred stock to
investors and loans the proceeds of the issue to
the bank.
Interest on the loan equals dividends paid on
preferred stock.
The loan is tax deductible such that the bank
deducts dividend payments.
As a bonus, the preferred stock counts as Tier 1
capital!!
Capital planning
 Capital planning is part of the overall asset and
liability management process.
 Bank management makes decisions regarding
the amount of risk assumed in operations and
potential returns.
 The amount and type of capital required is
determined simultaneously with the expected
composition of assets and liabilities and
forecasts of income and expenses.
 The greater is assumed risk and asset growth,
the greater is required capital.
Capital planning: forecast performance measures for a
bank with deficient capital ratios
2001
2002
2003
2004
Historical 10% Growth in Assets: $250,000 In Dividends
Total assets
$ 80.00
$ 88.00
$ 96.80 $ 106.48
Net interest margin
4.40%
4.40%
4.50%
4.60%
ROA
0.45%
0.45%
0.60%
0.65%
Total capital
$ 5.60
$ 5.75
$ 6.08
$ 6.52
Capital ratio
7.00%
6.53%
6.28%
6.12%
2005
$ 117.13
4.70%
0.75%
$ 7.15
6.10%
Shrink the Bank, reduce assets by $1 million a year: $250,000 In Dividends
Total assets
$ 80.00
$ 79.00
$ 78.00
$ 77.00
$ 76.00
Net interest margin
4.40%
4.40%
4.50%
4.60%
4.70%
ROA
0.45%
0.45%
0.60%
0.65%
0.75%
Total capital
$ 5.60
$ 5.71
$ 5.92
$ 6.17
$ 6.49
Capital ratio
7.00%
7.22%
7.59%
8.02%
8.54%
Slow Growth, $2 million increase in assets each year: No Dividends
Total assets
$ 80.00
$ 82.00
$ 84.00
$ 86.00
$ 88.00
Net interest margin
4.40%
4.40%
4.50%
4.60%
4.70%
ROA
0.45%
0.45%
0.60%
0.65%
0.75%
Total capital
$ 5.60
$ 5.97
$ 6.47
$ 7.03
$ 7.69
Capital ratio
7.00%
7.28%
7.71%
8.18%
8.74%
Slow Growth, $2 million increase in assets each year:
$250,000 In Dividends, $800,000 External Capital Injection In 2004
Total assets
$ 80.00
$ 82.00
$ 84.00
$ 86.00
Net interest margin
4.40%
4.40%
4.50%
4.60%
ROA
0.45%
0.45%
0.60%
0.65%
Total capital
$ 5.60
$ 5.72
$ 5.97
$ 7.08
Capital ratio
7.00%
6.97%
7.11%
8.23%
$ 88.00
4.70%
0.75%
$ 7.49
8.51%
Federal deposit insurance
 The Banking Act of 1933 established the FDIC
and authorized federal insurance for bank
deposits up to $2,500, today coverage stands
at $100,000 per account.
 The initial objectives of deposit insurance were
to prevent liquidity crises caused by largescale deposit withdrawals and to protect
depositors of modes means against a bank
failure.
 The large number of failures in the late 1980s
and early 1990s put pressure on the FDIC by
slowly depleting the reserve fund.
By the late 1990’s, the FDIC was well
funded
 Financial Institution Reform, Recovery, and
Enforcement Act of 1989 (FIRREA) authorized
the issuance of bonds to finance the bailout
of the FSLIC and provide resources to close
problem thrifts.
 The Deposit Insurance Funds Act of 1996
(DIFA) was enacted on September 30, 1996
1.
2.
3.
Included both a one-time assessment on SAIF
deposits to capitalize the SAIF fund
Required the repayment of the Financing
Corporation (FICO) bonds
Mandated the ultimate elimination of the BIF
and SAIF funds by merging them into a new
Deposit Insurance Fund
Risk-based deposit insurance
 FDIC insurance premiums are assessed based
on a Risk-Based Deposit Insurance system
required by the FDIC Improvement Act of 1991
and adopted in September 1992.
 These premiums are reviewed semiannually by
the FDIC to ensure that:


premiums appropriately reflect the risks posed
to the insurance funds and
that fund reserve ratios are maintained at or
above the target Designated Reserve Ratio
(DRR) of 1.25 percent of insured deposits
 Deposit insurance premiums are assessed as
basis points per one hundred dollars of
insured deposits.
FDIC reserve ratios, fund balance,
and insured deposits
Insurance Fund Balance as a Percent of Total Insured Deposits
1.75%
BIF
SAIF
1.50%
1.25%
Target Ratio
1.00%
0.75%
0.50%
0.25%
0.00%
1991
-0.25%
-0.50%
1992
1993
1994
1995
1996
Year
1997
1998
1999
2000
2001
At the beginning of 2002, over 93% of
banks are listed in the lowest category and
pay no FDIC insurance premiums.
Capital Group
Well capitalized
Adequately capitalized
Undercapitalized
Supervisory Subgroups
A
B
C
0 bp
3 bp
17 bp
3 bp
10 bp
24 bp
10 bp
24 bp
27 bp
Problems with deposit insurance
 Government backed deposit insurance
provides for stability of the financial system
by reducing or preventing banking panics
and protecting the less sophisticated
depositor — but this come at a price.
Problems with deposit insurance
…First, deposit insurance acts similarly to bank
capital and is a substitute for some functions of
bank capital.
 In noninsured industries, investors or depositors look to the
company’s capital as a safety net in the event of failure.
 All else equal, lower capital levels mean that the company must
pay a risk premium to attract funds or they will find it very difficult
if not impossible to borrow money.
 In banking, a large portion of borrowed funds come from
insured depositors who do not look to the bank’s capital
position in the event of default
 A large number of depositors, therefore, do not require a risk
premium to be paid by the bank.
 Normal market discipline in which higher risk requires the
bank to pay a risk premium does not apply to all providers of
funds.
 In addition to insured depositors, many large banks are
considered to be “too-big-to-fail” (TBTF).
 As such, any creditor of a large bank would receive de facto
100 percent insurance coverage regardless of the size or type
of liability.
Problems with deposit insurance
…Second, deposit insurance has historically
ignored the riskiness of a bank’s operations,
which represents the critical factor that leads to
failure.
 Thus, two banks with equal amounts of domestic
deposits paid the same insurance premium, even
though one invested heavily in risky loans and had
no uninsured deposits while the other owned only
U.S. government securities and just 50 percent of
its deposits were fully insured.
 This creates a moral hazard problem whereby
bank managers had an incentive to increase risk.


For example, suppose that a bank had a large
portfolio of problem assets that was generating little
revenue.
Managers could use deposit insurance to access
funds via brokered CDs in $100,000 blocks.
Problems with deposit insurance
… Third, deposit insurance funds were always viewed as
providing basic insurance coverage.
 Historicall, there were three fundamental problems with the
pricing of deposit insurance.

Premium levels were not sufficient to cover potential payouts.



Regardless, deposit insurance coverage slowly increased
from $15,000 per account per institution in 1966 to $20,000
in 1969, $40,000 in 1974, and $100,000 in 1980.


The FDIC and FSLIC were initially expected to establish
reserves amounting to 5 percent of covered deposits funded by
premiums.
Unfortunately, actual reserves never exceeded two percent of
insured deposits as Congress kept increasing coverage while
insurance premiums remained constant.
Even then, customers could obtain multiple account coverage at
any single institution by carefully structuring ownership of each
account.
The high rate of failures during the 1980s and the insurance
funds demonstrate that premiums were inadequate.
Problems with deposit insurance
… The final historical problem with deposit
insurance is that premiums were not assessed
against all of a bank’s insured liabilities.
 There were many liabilities that the federal government effectively
guaranteed or where the holders had a prior claim on bank assets, that
should have required insurance premiums.
 For example, insured deposits consisted only of domestic deposits
while foreign deposits were exempt.




The argument for not charging premiums against foreign deposits is
that U.S. banks would be less competitive with foreign bank
competitors.
Too-big-to-fail doctrine toward large banks means that large banks
would have coverage on 100 percent of their deposits but pay for
the same coverage as if they only had $100,000 coverage as
smaller banks do.
This means that regulators were much more willing to fail smaller
banks and force uninsured depositors and other creditors to take
losses.
If a bank’s liabilities were covered by federal insurance, the firm
should have paid insurance premiums.
Bank Management, 5th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning
THE EFFECTIVE USE OF
CAPITAL
Chapter 13