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by the Congress of another independent Federal examining authority would constitute an obstacle to State bank membership in the Federal Reserve System and I have been advised by presidents of the Federal Reserve banks would lead to withdrawals from the System. As a result, the effectiveness of Federal credit and monetary policies would be weakened.

INAPPROPRIATE WAY OF REALINING FEDERAL SUPERVISORY AUTHORITY

I should like to emp size the Board's opinion that realinement of bank examination and supervisory functions of the three Federal bank supervisory agencies is not a matter which should be dealt with in a piecemeal fashion or as an incident to a bill designed primarily for other ends. The Board feels that, should the Congress wish to deal with the problem of organization and functioning of the Federal bank examination and supervisory establishment, it should do so only after a careful study by the Banking and Currency Committees for the specific purpose of determining the advisability of legislation in this field.

CONCLUDING COMMENT

In conclusion, I should like to reemphasize the Board's strong sympathy for the objectives of this proposed bill relating to the insurance coverage, the payment of dividends, the assessment base, the simplification of the assessment computation, and the liberalization of the loan and asset purchase powers of the Corporation. We question whether any of the other provisions of this bill are essential at this time. There has been only a very short period within which to examine all of the provisions in detail. It is quite possible that, on further study of the detailed provisions of the bill, we would have additional suggestions to make and, if so, we hope the committee will permit us to do so.

ASSESSMENTS ÀND COVERAGE FOR DEPOSIT INSURANCE

(Staff study prepared for the Board of Governors of the Federal Reserve System)

MEMORANDUM-STAFF SUGGESTIONS FOR DEPOSIT INSURANCE REFORM

To: Board of Governors.
From: Senior Staff.

Submitted herewith is a comprehensive study of the Government's deposit insurance program, prepared by the Banking Section of the Division of Research and Statistics in response to the Board's action, taken on March 11, 1949, requesting such a study. The study was circulated in preliminary draft to members of the Board's senior staff for criticism and comment. The present and final draft is a revision based on the many suggestions received from senior staff members.

A major question to which the study is directed is whether the present benefits of insurance-i. e., level of insurance coverage can and should be increased at this time.

The senior staff concurs in the conclusion reached in the study that the answer is in the affirmative. Staff viewpoints differ on how far public policy should go in raising present insurance coverage. There is a consensus, however, that the Board could properly favor an increase in deposit coverage to at least $10,000 considering the sharp increase in the general price level, the average level of income, and bank deposits since prewar years. The coverage might reasonably be as high as $25,000 in view of these changes and at the same time recognize the conflicting arguments for limited and full (or substantially full) coverage of deposits.

Another major question with which the study is concerned is whether the present assessment burden on banks can safely be modified at this stage. The senior staff concurs with the conclusion reached that the answer to this question is in the affirmative. The senior staff also concurs with the conclusion that a downward revision of assessments, resulting in increased bank earnings, would greatly strengthen the position of the supervisory authorities in their efforts to encourage the progressive increase of bank capital.

of the several alternatives for effecting such moderation, the senior staff favors the statutory formula suggested by the study which would relate the rate of assessment to average loss experience over the previous 10-year period, and be geared to maintain a maximum reserve fund of about 3 percent of total deposits, less cash assets and Government securities, of insured banks. This formula would allow the fund to decline in periods of banking difficulty without a sharp rise in assessment rates, leaving the rebuilding of the fund at higher assessment rates to more prosperous periods. A formula along such lines would be reasonably consistent with the one suggested by the American Bankers Association, but would not have the rigidity and procyclical effect of that organization's proposals.

An alternative regarded favorably by some staff members is a discretionary authority for the bank supervisory authorities to vary the assessment rate within prescribed limits according to certain statutory criteria. This alternative raises difficult problems of administrative responsibility and does not seem likely to receive support from the banking community.

A technical revision in the method of calculating the assessment base that has merit and, in the staff's opinion, should be strongly favored by the Board, is to make consistent the definitions of deposits for insurance and for reserve and call report purposes. The procedures for calculating the deposit base for each bank could be simplified by using deposits as reported for selected dates instead of the daily average of deposits now used.

The study considers possible changes in the assessment base that effect some reduction in the assessment burden on insured banks. The staff concurs that such methods are a circuitous means of accomplishing the end of a moderation of the assessment burden; generally speaki they are not favored.

Attachment.

ASSESSMENTS AND COVERAGE FOR DEPOSIT INSURANCE

SUMMARY OF CONCLUSIONS

After 15 years of operations, the FDIC has accumulated from assessment receipts and other earnings an insurance fund of more than 1 billion dollars. With this huge reserve fund increasing rapidly (and considering the drawing fund of 3 billion dollars which the Corporation has with the Treasury), it is appropriate to reexamine the whole matter of public policy with regard to deposit insurance.

The basic question is whether, for all practical purposes, the existing reserve fund for deposit insurance is now large enough. The answer indicated in this study is that the fund is now approaching such a size.

Three further questions therefore need consideration : first, whether the present benefits of the insurance should be increased ; secondly, should a revised assessment formula be established that would moderate the assessment burden on insured banks; and thirdly, could both of these steps be taken at this time. The conclusions of this study with respect to these questions are in the affirmative and are set forth below:

Increase in deposit coverage.--At present deposit insurance is extended on all deposit accounts but with a maximum coverage for individual accounts of $5,000. With this coverage, about half of the total dollar amount of bank deposits are insured; in small banks where the accounts tend to be small, the proportion of deposits insured is relatively high; in large banks, where most of the large deposits are held, the proportion of deposits insured is relatively small.

The principal objection to an extension of deposit insurance coverage is based on the belief that the watchfulness of large depositors helps to promote sound banking practices. It is felt by some observers that any substantial increase in coverage, especially to full deposit coverage, would result in an inevitable encroachment by supervisory authorities on bank management responsibilities.

On the other hand, the weight of argument is in favor of some increase in the coverage of deposit insurance. Added coverage may help in achieving more fully both of the major objectives of deposit insurance-protection of the individual depositor and promotion of stability in the economy as a whole through protection of the money supply and maintenance of public confidence in banks. The sharp increase in the general price. level, average level of incomes, and bank deposits since prewar has made the existing coverage less adequate than it was 15 years ago. Expanded coverage would also prove of advantage to smaller banks in getting and retaining larger deposit accounts and further would correct in part the unevenness of the insurance burden relative to statutory coverage as it is presently distributed among large and small banks.

As the FDIC currently functions, great emphasis is placed on keeping “trouble” banks in active operation through reorganization and mergers rather than

allowing them to be closed and paying off promptly just the insured depositors. This method of operation has been found to be cheaper to the FDIC and has the great advantage of protecting communities against the depressing effects of bank failures. If the present fund is adequate to support an operating procedure of this kind at current levels of insurance coverage, there is no reason for thinking that it would be less adequate at higher levels of coverage.

Moderation of the assessment burden.-If the deposit insurance reserve is not to be increased indefinitely without regard for probable adequacy, the present scheme of insurance assessment must be revised at an early stage. Furthermore, a downward revision of assessments, resulting in increased bank earnings, would greatly strengthen the position of the supervisory authorities in their efforts to encourage the progressive increase of bank capital.

Some reduction in the assessment burden could be effected by permitting deductions from the assessment base for vault cash and reserves against deposits, and perhaps for other riskless assets such as short-term Government securities. A combination of such allowances, at the present assessment rate, would reduce premium payments about $40,000,000. This approach, however, to the problem of moderating the assessment burden on insured banks is a circuitous way of accomplishing what might better be done directly.

The burden on banks of the insurance assessment could be moderated in direct fashion by lowering, at least for extended periods, the assessment rate. One proposal, supported by banker groups, would provide for the establishment of a statutory formula for an automatic scale of assessments, based on the previous year's losses, to range from a nominal assessment up to one-twelfth of 1 percent. This plan, however, would have a procyclical impact on banks in that it would provide for raising rates sharply in periods of banking difficulties and dropping rates rapidly as conditions became favorable.

It would be preferable to moderate the assessment burden through some alternative formula which would minimize the procyclical effect by providing for an automatically varied premium rate under a statutory formula allowing the fund to decline in periods of banking difficulty without a sharp rise in assessment rates, and leaving the rebuilding of the fund to a more gradual process. The present level of the fund would be maintained over the long run, but the formula would not place banks under additional strain in periods of banking difficulties by raising premium rates abruptly. A formula along these lines would be entirely feasible. For this purpose, the rate of assessment could be related to average loss experience over the previous 10-year period. Either the reserves of more than $1,100,000,000 that have now been accumulated could be considered a maximum, or provision might be made for tying the maximum size of the fund to the volume of deposits to allow automatically for any future substantial growth in deposits.

Still another way of making provision for lowering the present assessment burden would be to give to the Corporation authority, after consultation with other agencies such as the Federal Reserve Board and the Secretary of the Treasury, to vary the assessment rate within statutory limits. It is doubtful, however, whether such an arrangement would offer any important advantages as against the formula proposed.

Whatever action may be taken to moderate the assessments burden on insured banks, there is a need for technical changes to simplify the procedures for computation of the assessment base such as use of deposists as of selected date instead of the daily average of deposits, and to make consistent the definitions of terms used in determining the volume of deposits for insurance assessment purposes and for reserve and call report purposes.

Timing of above reforms.-The above reforms in deposit insurance programan increase in coverage and provision for easing the assessment burden on banks—are sometimes considered as mutually exclusive alternatives. The conclusion of this study, however, is that both major steps could be taken concurrently, and that early legislative action for this purpose would be appropriate.

Since the establishment of a national system of deposit insurance, there have been numerous suggestions for its amendment, some reaching the status of bills before the Congress. In general these proposals fall into two groups: Those favoring an increase in the amount of deposits insured, and those favoring decreases in the base or rate of assessment. Some proposals incorporate elements of both groups; larger deposit coverage with a reduction in the assessment rate and/or base.

Renewed interest in the whole subject of deposit insurance has been stimulated by the size of the insurance fund and the rate at which it has been increasing

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in recent years. It has been possible for the Federal Deposit Insurance Corporation to build the insurance fund to more than $1,100,000,000, while repaying the $289,000,000 contribution to capital made originally by the Treasury and the Federal Reserve banks. Currently (at present deposit levels) assessments are adding more than $100,000,000 a year to the fund. Interest from invested funds and other income more than pays for operational costs and current losses. In 1947, $38,000,000 was added to the fund from this source alone.

The powers granted to the Corporation permit loans on and purchase of assets for the purpose of amalgamating distressed banks with stronger banks. These powers have provided the Corporation with a very effective alternate procedure for dealing with banks in difficulty. This alternate procedure has resulted in much smaller losses than would have come from outright liquidation proceedings and consequently required less recourse to the insurance funds.

INTEREST OF THE FEDERAL RESERVE SYSTEM IN DEPOSIT INSURANCE

As the agent primarily responsible for monetary stability, the Federal Reserve System is vitally interested in the functioning of an insurance program which has as its primary objective the removal of one of the prime causes of monetary instability. Deposit insurance is potentially one of the more important reforms directed to greater monetary stability by the banking legislation of the 1930's. In essence, these banking reforms aimed at preventing a repetition of the wholesale destruction of the money supply that occurred between 1929–33. To that end the Board of Governors, among other things, was authorized to vary reserve requirements within certain limits, and to prescribe margin requirements on listed stocks the Federal Reserve banks were authorized to grant credit on any sound bank asset, and provisions for the issuance of Federal Reserve notes were liberalized.

It will be noted, however, that these changes in System powers, while providing the necessary elasticity in the banking system to cope with adverse conditions, deal only indirectly with one of the casual factors which in the past have greatly aggravated cyclical developments, namely, panic conditions among depositors. Deposit insurance is the instrument set up to prevent that considerable part of a liquidating process which is due to the panic withdrawal of funds by the general public.

System interest in possible changes in deposit insurance arises also from another feature of the deposit-insurance plan. Under the existing arrangement, member banks pay a disproportionate share of the insurance cost. The assessment base is total deposits less cash items in process of collection, and each bank pays roughly in proportion to the amount of its total deposits, regardless of how much of these deposits are covered by insurance. Since insurance coverage is limited to amounts of $5,000 or less, and the large accounts are in larger banks, it is generally true that the larger the bank the smaller the proportion of its deposits covered. Member banks have about 85 percent of the total assessment on commercial banks for deposit insurance. Yet member banks tend to run larger in size than nonmember banks, with the result that only about 37 percent of member bank deposits are covered as compared with about 72 percent for nonmember insured banks.

The Federal Reserye has a further interest in deposit insurance because of its effects on ability of banks individually to strengthen their capital accounts. Assessments constitute a considerable drain on bank earnings, thus hindering banks in their attempt to improve their individual capital positions. A decrease in assessments resulting in increased bank earnings would materially aid banks in attracting outside capital and in increasing their capital directly through retained earnings.

This study explores the three basic elements of deposit insurance coverage of insurance, assessment base, and rate of assessment-in order to make available pertinent information and consideration that should be taken into account in working out basic changes in the present arrangements.

THE NEED FOR DEPOSIT INSURANCE

The economic importance of deposit insurance stems from the fact that liabilities of banks are essentially demand liabilities to the public and that these liabilities constitute the country's principal means of payment, i. e., check money. All too often in our history panic shifting of funds from one bank to another and eventually panic withdrawals of funds by the public from the banking system

have forced the banks to liquidate assets at most unfavorable times. Distress calling of loans and forced liquidation of securities by banks and bank borrowers have led to widespread bank suspensions and to a drastic destruction of the principal part of the money supply-bank deposits.

Deposit insurance is useful in correcting these unfortunate periodic experiences from two major closely related viewpoints--that of the individual and that of the Nation. From the individual's standpoint, deposit insurance provides protection, within limits, against the banking hazards of deposit ownership. But the major virtue of deposit insurance is for the Nation as a whole. By assuring the public, individuals and businesses alike, that their cash in the form of bank deposits is insured up to a prescribed maximum, a major cause of instability in the Nation's money supply is removed. Preservation of public confidence in the banks makes for stability in the level of bank deposits and for stability in the economy as a whole.

BACKGROUND OF PRESENT LAW

Federal insurance of bank deposits grew out of the widespread bank failures of the 1920's and early 1930's. The Federal Deposit Insurance Corporation was established by the Banking Act of 1933, with amendments by the Banking Act of 1935.

There was little experience and information on which to base a scheme to insure bank depositors against loss. Rates of assessment, the assessment base, and insurance coverage all had to be determined more by current judgment than on the basis of actuarial experience. In fact, such experience as was available-various State deposit insurance funds-was so unfortunate that, had it been used, insurance rates might well have been prohibitive.

In recommending the present rates and base, the FDIC had some data on annual rates of loss to depositors for the period beginning 1863. As eventually revised, covering the period 1863–1940, these data show that annual losses to depositors from bank suspensions ranged from less than 0.01 percent of all deposits in operating banks to slightly more than 2 percent. It is estimated that about two-thirds of the total losses to depositors in closed banks over the 76 years occurred in 12 particular years, 1873, 1875–78, 1884, 1891, 1893, and 1930-33. About half of the total loss was in the 1930–33 period. Present assessment rate

The statutory assessment rate was set as follows: Total losses to depositors in closed or suspended commercial banks for the period 1863–1933 were estimated at about 2.7 billion dollars, excluding assessments of about 500 million dollars from bank stockholders (actual loss about 2.2 billion dollars), or an average annual rate of one-fifth of 1 percent of deposits in operating banks. Deposit balances not exceeding $5,000 were estimated to have accounted for approximately three-fourths of these losses. The annual average rate of assessment necessary to have covered losses on these deposit balances would have been about one-seventh of 1 percent of total deposits (less cash collection items) in operating banks. It was assumed that banking reforms would eliminate repetition of the so-called crisis years mentioned earlier in which losses to depositors were heavy. Losses in the noncrisis years were one-twelfth of 1 percent for all deposits in active banks. The rate then is the equivalent of closed bank losses against all deposits in the noncrisis years. Present assessment base

The statutory assessment base selected for Federal insurance of deposits was total deposits plus trust funds less cash items in the process of collection. This base was selected despite the fact that many banks would have essentially full coverage out of the common fund whereas others, mainly the larger banks, a large proportion of whose deposits would represent large accounts, would have a considerably smaller proportion of their deposits insured. It was thought that the indirect benefits from deposit insurance for larger banks fully justified their more than proportionate assessment contribution. Limitation of insurance to deposits of $5,000 and under

The limitation of Federal deposit insurance to bank deposits of $5,000 and under was frankly designed to insure the mass of depositors with small accounts. With this limitation on coverage, about 98 percent of depositors were fully insured. . As a result of the increase in the average size of deposits in recent years, the proportion has fallen slightly to about 96 percent at present.

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