Deposit Insurance and Risk Management of the U.S. Banking System: How Much? How Safe? Who Pays?

Financial Institutions Center Deposit Insurance and Risk Management of the U.S. Banking System: How Much? How Safe? Who Pays? by Andrew Kuritzkes Til Schuermann Scott Weiner 02-02-B The Wharton Financial Institutions Center The Wharton Financial Institutions Center provides a multi-disciplinary research approachto the problems and opportunities facing the financial services industry in its search for competitive excellence. The Center`s research focuses on the issues related to managing risk at the firm level as well as ways to improve productivity and performance. The Center fosters the development of a community of faculty, visiting scholars and Ph.D. candidates whose research interests complement and support the mission of the Center. The Center works closely with industry executives and practitioners to ensure that its research is informed by the operating realities and competitive demands facing industry participants as they pursue competitive excellence. Copies of the working papers summarized here are available from the Center. If you would like to learn more about the Center or become a member of our research community, please let us know of your interest. Franklin Allen Co-Director Richard J. Herring Co-Director The Working Paper Series is made possible by a generous grant from the Alfred P. Sloan Foundation Deposit Insurance and Risk Management of the U.S. Banking System: How Much? How Safe? Who Pays?1 Andrew Kuritzkes Oliver, Wyman & Company 99 Park Ave. New York, NY 10103 akuritzkes@owc.com Til Schuermann2 Federal Reserve Bank of New York 33 Liberty St. New York, NY 10045 til.schuermann@ny.frb.org Scott M. Weiner Oliver, Wyman & Company 99 Park Ave. New York, NY 10103 sweiner@owc.com First Draft: July, 2000 This Draft: April 29, 2002 This Print: April 29, 2002 Abstract: We examine the question of deposit insurance through the lens of risk management by addressing three key issues: 1) how big should the fund be; 2) how should coverage be priced; and 3) who pays in the event of loss. We propose a risk-based premium system that is explicitly based on the loss distribution faced by the FDIC. The loss distribution can be used to determine the appropriate level of fund adequacy and reserving in terms of a stated confidence interval and to identify risk-based pricing options. We explicitly estimate that distribution using two different approaches and find that reserves are sufficient to cover roughly 99.85% of the loss distribution corresponding to about a BBB+ rating. We then identify three risk-sharing alternatives addressing who is responsible for funding losses in different parts of the loss distribution. We show in an example that expected loss based pricing, while appropriately penalizing riskier banks, also penalizes smaller banks. By contrast, unexpected loss contribution based pricing significantly penalizes very large banks because large exposures contribute disproportionately to overall (FDIC) portfolio risk. Keywords: Deposit insurance pricing, loss distribution, risk-based premiums. JEL Codes: G210, G280 1 We would like to thank Rosalind Bennett, Marc Intrater, Rick Mishkin, Art Murton, Jim Stoker, an anonymous referee and the participants of the Banking Studies Brown Bag at the FRBNY for their insightful comments. We would also like to thank John O’Keefe, Donald Inscoe and Ross Waldrop for providing us with some of the BIF bank-level data, and Sorin Talamba for his excellent research assistance. All remaining errors are ours. 2 Corresponding author. Any views expressed represent those of the author only and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System. 1. Introduction At the end of 2000, the FDIC Bank Insurance Fund (BIF) had 8571 institutions as members comprising $6.5tn in assets and about $2.5tn in insured deposits. The fund had a balance of $31bn to cover this exposure.3 Was that enough? What does “enough” mean? Motivated by similar questions and concerns, the FDIC issued an options paper on regulatory reform in August, 2000, that discussed weaknesses in the present deposit insurance system and offered possible solutions.4 Whatever the merits or faults of deposit insurance are (and we will discuss these briefly below), any reform needs to address three key issues: 1) how big should the fund be; 2) how should coverage be priced; and 3) who pays in the event of loss. We take a novel approach and argue that the answer to those questions can be found in some of the same risk management techniques used by banks to manage their (mostly asset) risk. After all, the FDIC is managing a portfolio of credit assets, consisting of contingent exposures to the banks it insures. Therefore the risk management problem faced by the FDIC is directly related to the riskiness of the individual banks in its portfolio. This problem can be broken down into the familiar components of contemporary credit analysis: the probability of an insured bank defaulting (PD), the severity (or loss given default – LGD) of pay-out in the event of a claim, the size of the claim in the event of default (exposure), and the likelihood that several of these adverse events will occur at the same time (default or loss correlation). These factors can be used to estimate the cumulative loss distribution of FDIC insured banks and – critically for policy questions such as pricing of deposit premiums – to frame 3 The FDIC has two funds: the BIF and the smaller Savings Association Insurance Fund (SAIF) which at that time had a balance of $10.9 bn to cover about $750 bn of insured deposits. 4 http://www.fdic.gov/deposit/insurance/initiative/OptionPaper.html. See also the commentary on the options paper by Blinder and Wescott (2001). -1- a discussion about who “owns” which parts of that distribution. We explicitly estimate that distribution for the U.S. banking system using two variations of an options-based approach à la Merton (1974) and include plausible stress scenarios to provide further insight into tail behavior. In the first application of options theory to deposit insurance pricing, Merton (1977) points out that deposit insurance is much like a loan guarantee and should be priced accordingly. Using Merton’s approach, Marcus and Shaked (1984) found that the deposit insurance pricing schedule in effect at that time was far too flat (high risk banks paid similar rates as low risk banks -- still true today), and that the FDIC significantly overpriced deposit insurance.5 In a theoretical paper, Buser, Chen and Kane (1981) argue the other way, namely that the FDIC intentionally sets premiums too low to induce banks to purchase insurance and submit themselves to FDIC regulatory restrictions. Pennacchi (1987), in an attempt to settle the debate of under vs. overpricing, questions the degree of regulatory control and impact the FDIC really has. By allowing for a range of control, Pennacchi computes pricing bounds, and the actual premiums the FDIC charged at the time were contained within those bounds. Interestingly, under the assumption of low effective regulatory control, the estimates indicate under-pricing of premiums, a prescient result given that his study used data from 1978 – 1983, before the worst of the S&L crisis. In a recent paper, Pennacchi (2002) develops a risk-based insurance premium pricing model using an insurance valuation approach. His methodology involves treating the insurance guarantee as a moving average of a series of long term insurance contracts. The pricing scheme is stable (i.e. address the procyclicality problem of the existing regime) yet subject to frequent updating. While 5 See also Ronn and Verma (1986) for a similar analysis. -2- ... - tailieumienphi.vn