Deposit Insurance and Bank Failures

A Brief History of Deposit Insurance

After a rash of bank failures in the early 1930s, Federal deposit insurance was enacted by Congress, but over strong opposition.  The opponents argued that it would encourage bad banking and eventually become a burden to the taxpayer.  But for the first time in the history of American banking, there was a lengthy period without bank runs or banking panics, and very few banks failed.  That all began to change in the 1970s.  It reached a crisis in the 1980s when bank failures, though less numerous, far exceeded the total assets (in constant dollars) of failed banks in the 1930s.

The S&L crisis of the 1980s wiped out the Federal Savings and Loan Insurance Corporation (FSLIC).  As a result, Congress revised the system.  In 1989 deposit insurance was consolidated under the Federal Deposit Insurance Corporation (FDIC).  Two funds were set up, the Bank Insurance Fund (BIF) which covers commercial banks and savings banks, and the Savings Association Insurance Fund (SAIF) which insures deposits at S&Ls.  The focus here is on deposit insurance as it relates to banks. 

Insured banks pay a premium on all their deposits, even those deposits that are not covered by insurance.  For many years, premium income exceeded the cost of failures.  But as the size of bank failures increased, the BIF went into the red in 1991.  Instead of being declared insolvent, however, its losses were covered with loans from the Treasury, as authorized by Congress.  In 1992 the fund staged a comeback.  With increased premiums and a sharp improvement in bank profitability due to a drop in the interest rates, the BIF repaid its loans and was well in the black again by mid-1993.

Dealing with Bank Failure

A bank is insolvent when its liabilities exceed its assets. The FDIC monitors the banks that it insures, but the authority to close a bank rests with whoever gave it a charter.  Once an insolvent bank is closed, there are three ways for the FDIC to proceed.  They are (1) a payout, (2) a purchase and assumption, or (3) a bridge bank.  We will examine each of these options.

  Payout

In a payout, the insolvent bank is liquidated and ceases to exist.  The FDIC pays off its insured depositors.  It then sells the bank’s assets and uses the proceeds to pay off the bank’s creditors.  These include the owners of uninsured deposits and the FDIC itself.  The FDIC becomes a creditor by purchasing the insured deposits.  The creditors share pro rata in whatever proceeds are realized from the liquidation.

  Purchase and Assumption

In a purchase and assumption (P&A), the FDIC arranges for another bank to purchase the failed bank and to assume it liabilities.  Banks interested submit bids in an auction process.  There are two versions of P&A.  In a clean-bank P&A, the successful bidder takes over the liabilities but not the assets.  The FDIC pays the bank the cash value of the liabilities less the amount of the bid.  It then liquidates the assets and keeps the proceeds. 

In a whole-bank P&A, the successful bidder takes over the assets as well as the liabilities.  The FDIC pays it the value of the liabilities less the market value of the assets, less the amount of the bid.  The net cost to the FDIC is the same in both versions, but the whole-bank version ties up less of its resources because it does not have to take on and liquidate the loans.  As the amount of the assets the FDIC has under liquidation has soared, it has increasingly leaned toward the whole-bank version.

  Bridge Bank

In the bridge bank option, the FDIC replaces the board of directors of the insolvent bank and provides whatever capital is required to reorganize it and get it running properly.  In exchange, the FDIC receives an equity stake in the bank.  While under the wing of the FDIC, the bank is known as a 'bridge bank' which continues until a P&A can be arranged or the bank returns to profitability.  In this version, not only are the liabilities covered, but the original owners may even come away with something.

FDIC Preferences Regarding Bank Failure

During most of its history, the FDIC has shown a preference for the P&A option.  Of the 1813 insured banks that failed between 1934 and 1990, only 552 were payouts.  Of the 169 banks that failed in 1990, 20 were payouts, 148 were P&As, and only one involved a bridge bank.

A payout is generally the least expensive for the FDIC because the lost value of the failed bank’s “franchise” is usually less than its uninsured liabilities.  In a P&A, all liabilities of the failed bank are covered – both insured and uninsured deposits as well as non-deposit liabilities such as Fed funds bought.  Cost however is not the main consideration.  If the FDIC believes that liquidation and its consequent losses to uninsured depositors and creditors would shake public confidence in the banking system, it may elect to bear the greater cost of a P&A.

The Moral Hazard Problem

The purpose of deposit insurance is to protect the banking system by eliminating bank runs. If all deposits were insured, the likelihood of bank runs would indeed be greatly reduced.  But that would also increase the moral hazard leading to riskier banking practice and outright failures.  This dilemma has no easy solution.