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Merger versus receivership procedure

There are two procedures by which the Corporation may protect the deposit holders of insured banks in financial difficulty. One is an advance or purchase of certain assets by the Corporation to facilitate assumption of the deposit liabilities of a weak or insolvent bank by another bank in the same or nearby community. The other is to act as receiver for an insolvent bank, paying off insured deposits. The merger method has been much more widely used in recent years. This method is clearly superior on several counts-ordinary business has not been disrupted by an interruption of banking services; all depositors have been protected; depositor losses to be met by the Corporation have been less severe; and undesirable repercussions on neighboring banks and communities have been held to a minimum.

THE RECORD-1934-47

Bank suspensions as well as bank-deposit losses have been small since Federal insurance of deposits was established. Over the period of more than 13 years, 1934-47, only 404 banks have required assistance. As is shown in table 1, 245 were placed in receivership and 159 were merged with other banks. Losses to the Corporation in these operations were about $26,000,000. Actual losses to depositors were less than $2,000,000 for the entire period.

TABLE 1.—Amount of deposits and losses in insured banks placed in receivership or merged with the financial aid of the Corporation, 1934–47

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Source: Annual Report of Federal Deposit Insurance Corporation for 1947, p. 14.

Precisely how much influence deposit insurance has had in this excellent record and how much must be credited to other factors cannot be determined. The entire period of the Corporation's existence except for a part of the years 1937-38 was one of rapidly expanding bank credit, generally rising prices, and expanding business activity. The violent bank upheaval of the early 1930's undoubtedly removed from business most banks not structurally sound or economically necessary, resulted in a drastic housecleaning of many banks which survived, and provided a good deal of hard-won experience for individual bankers. Bank supervision has also improved greatly as a result of the experience in the 1930's. Financial developments, too, particularly the enormous and continuous growth of the public debt over the period to 1946 and the stabilization of the Government security market by the Federal Reserve System have permitted banks to acquire a larger proportion of liquid assets than was the case in earlier years.

IS THE PRESENT INSURANCE FUND LARGE ENOUGH?

No one can say exactly what the size of the FDIC surplus fund should be if it is to be fully adequate to meet any contingency. It is not feasible to apply rigorous actuarial principles to bank-deposit insurance to determine precisely the size of the insurance reserve fund that is needed. Historically losses to depositors through bank closings have been concentrated in particular periods of economic upheaval. These losses could not have been forecast either as to timing or amount. On the basis of the generally recognized principle that most bank assets are sound, assuming integrity of management, losses to depositors or to an insurance fund should be low providing there is time and opportunity to liquidate the bank assets in an orderly fashion. Under such conditions, an insurance fund of the present size should be more than adequate to take care of ultimate losses.

When public loss of confidence in banks becomes a major factor, however, a larger fund is needed in order to pay off depositors and hold assets until conditions are proper for their liquidation, and for this reason the

FDIC now has a drawing fund available from the Treasury of $3,000,000,000 and authority to issue debentures to the public and borrow from the RFC. If confidence is fully undermined, then no reasonable fund would be large enough to meet liquidation problems arising from panic withdrawals of deposits. But provision for ultimate liquidity of deposits is basically not properly the task of an insurance fund; it is the responsibility of the central bank-i. e., the Federal Reserve System. Under the legislation of the thirties, the System is in a greatly strengthened position to discharge that task.

At present the insurance fund is very large and is growing rapidly. At the end of 1948 it was about $1,100,000,000, an amount approximately equal to the total reported losses of all depositors in the 1930-33 period. Assessments paid by all insured banks are currently about $120,000,000 a year, as is shown in table 2. Of particular interest is the very large current income from investments. Almost a quarter of a billion dollars has been added to the insurance fund from this source. This sum is almost three times the total expenses of the Corporation since its beginning, and more than nine times the deposit-insurance losses and expenditures since 1935. Moreover, while the Corporation's expenses have tended to remain relatively constant, income from investments has tended to increase at a rapid rate. The investment income, of course, is in addition to assessments.

TABLE 2.-Income and expenses of the Federal Deposit Insurance Corporation since beginning operations

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Source: Annual Report of the Federal Deposit Insurance Corporation for 1947, p. 28, and FDIC Report to Insured Banks, Dec. 31, 1948.

The fund was set up for paying off ultimate losses of bank deposits to depositors in amounts of $5,000 or less. Actually the Corporation has two functions and uses the fund in both. First, it is a liquidating or merger agency and secondly, it is the insurance agency which absorbs losses arising out of its liquidating activity. As a liquidating agency, it acts as a receiver, pays off insured depositors as fast as claims can be proved, and attempts to realize on assets of liquidated banks. It is, however, only the difference between the realized value of the assets and the amount paid to meet depositors' claims that needs to be absorbed in its insurance function.

The liquidating function requires the availability to the FDIC of a large amount of money. Bank assets cannot be liquidated overnight; indeed, public policy might and probably would require that such assets should be held for gradual liquidation, particularly in the event of wide-scale suspensions. It was to meet this need that the FDIC was given a $3,000,000,000 drawing fund at the United States Treasury and authority to issue debentures to the public and to borrow from the RFC. On the other hand, the size of the fund needed for the insurance function--and this is the fund that should be provided out of assess

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AMENDMENTS TO FEDERAL DEPOSIT INSURANCE ACT

ments and investment income is related only to the losses (over and above those covered by bank capital) that would be sustained in the final liquidation of assets.

Those who believe that the insurance fund is not now large enough have called attention principally to the decline in the ratio of bank capital to bank assets, to a recent increase in substandard assets, and to the danger of rising losses from defalcation by bank employees. The decline in the ratio of bank capital to bank assets has been substantial. During the twenties and in the middle thirties, member bank capital averaged between 11 and 14 percent of total member bank assets. After 1938, and particularly during the early war years (193943) this ratio declined sharply to about 6 percent, and since 1944 has risen slightly to 7 percent as of April 1949. Most of the asset expansion since 1938, however, has been due to larger bank holdings of United States Government securities which are free of credit risk. The ratio for member banks of capital to risk assets is currently considerably higher than in the twenties, although below the level of the thirties and war years, both periods when bank lending operations were abnormally curtailed. In 1947 and 1948, banks added to their capital at about the same rate as they increased their risk assets, and so the ratio of capital to risk assets has remained about unchanged.

Available statistical evidence does not indicate that any significant deterioration in the quality of bank assets has occurred in recent years. According to an FDIC report to insured banks, dated February 23, 1949, there has been a steady improvement in the quality of bank assets over the past 15 years. In 1948 the volume of substandard assets was only about one-half of 1 percent of total assets, slightly more than 2 years ago but very much less than in 1939, when they comprised 5 percent of total bank assets. Further evidence of a significant quality improvement in bank assets since 1933 is given in table 3. United States Government securities now represent about 40 percent of total assets of insured banks as compared with 8 percent in 1929, and 28 percent in 1939. This is true despite a record-breaking increase in loans in the past several years. Loans as a whole have decreased in relative importance from about 55 percent in 1929 to about 28 percent in 1948 of bank assets.

TABLE 3.-Assets of insured banks for selected years-Percentage distribution

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What the table cannot show is improvement in risk quality of the loan portfolio. For example, although real-estate loans represent almost identical proportions of total assets in 1948 and in 1929, provisions for amortization plus the fact that much of the real-estate loan portfolio is guaranteed by Federal agencies put these loans in a much-improved risk category. Moreover, improved risk quality applies in varying degrees to other categories of the loan portfolio.

Defalcations were an important or controlling factor in the difficulties of five (and perhaps 6) of the total of seven banks whose depositors the Corporation was called upon to protect in 1945, 1946, and 1947. The problems that arose were related to the fact that fidelity protection was not in keeping with the risks and

responsibilities involved. While defalcations have been an important cause with the very few banks that have experienced difficulties recently, they can scarcely be considered of large enough general importance to place the present deposit insurance fund in jeopardy. In any event, the remedy is greater bank fidelity coverage, not a larger deposit insurance fund.

Effect of reduced assessments on bank capital accounts

Reflecting the large increase in bank deposits in relation to capital since prewar years, banks generally have been under continuous pressure from supervisory authorities to strengthen their capital positions through reinvesting earnings and through sales of additional capital stock. From a long-range point of view, the steady strengthening of bank capital positions is necessary if banks are to function effectively in financing expansion of American business. The shares of many banks are now selling at a discount from their liquidating values. As a result, these institutions are finding it difficult to sell additional stock at prices considered attractive to bank management.

A reduction of FDIC assessments from one-twelfth to one-fiftieth of 1 percent would amount to about $90,000,000, or about 12 percent of bank net profits in 1948. An increase in bank profits of this amount should enable banks to plow back more earnings into capital accounts and to float new issues of capital stock at more satisfactory prices. Such an increase in bank earnings, moreover, would greatly help the supervisory authorities in their efforts to encourage banks to increase their capital.

Can the assessment rate safely be cut?

In view of the size of the insurance fund at the present time, the answer to this question is believed to be in the affirmative. The question of what kind of a formula might be used to effect such a cut is considered in following sections. Can the insurance coverage be increased?

Some discussions of the status of deposit insurance have been predicated on the assumption that either the assessment might be cut or the coverage of deposit insurance could be increased. These two courses of action, however, are not necessarily mutually exclusive. In the following section it is suggested that extension of the coverage of deposit insurance might strengthen rather than weaken the adequacy of the present fund by increasing public confidence in banks. Further, it is not true as a practical matter that the insurance liabilities of the FDIC would be much if any increased by an increase in coverage, say to $10,000 or even to $25,000. The Corporation now in fact tends to protect all deposits through its merger procedure described in a preceding section.

PROPOSALS RELATING TO INSURANCE COVERAGE

With respect to deposit insurance coverage, three types of proposals have been made. First, there are those who hold that the present coverage is adequate and that there should be no change. Secondly, it has been suggested that all deposits should be insured. Thirdly, bills now pending in Congress would double or triple the coverage of deposit insurance. The advantages and disadvantages of these alternatives are discussed below.

No change in coverage

Arguments for no change in deposit insurance coverage generally fall into one of the following three broad categories:

1. The fund is not large enough to meet the potential liabilities arising out of increased coverage.

2. In an independent unit banking system such as ours, it would not be advisable to increase insurance coverage because the policing influence that large depositors exert for the promotion of sound banking practices would be removed and the role of the bank supervisory authorities would be correspondingly expanded.

3. The banking legislation of the thirties corrected the deficiencies in the banking system which gave rise to large deposit losses and depositor panic and in consequence no insurance at all is really needed. Thus, no increase in insurance coverage is required.

The question whether the fund is large enough now to support increased coverage was discussed in a previous section, with the answer in the affirmative.

The second objection to a change in coverage of deposit insurance is in part based on the feeling that such extension would result in placing a "premium on bad banking." That is to say, if full deposit insurance coverage were in effect, it would tend to lift the influence that watchful, large depositors may have over the loan and investment and other policies of bankers. Even if deposit insurance were increased to some amount greater than $5,000 but less than full coverage, a smaller group of individuals than now would be concerned with the safety of their deposits and consequently with the solvency of their banks. It is difficult to evaluate in specific terms the extent of this kind of influence. Undoubedly, bankers are restrained, in many cases, from going heavily into certain types of credit in part by the knowledge that some large depositors are following closely the bank's lending and investing policies and may withdraw their funds if disturbed by a movement of the bank into more risky assets. "Conservative banking," under full or substantially increased coverage might no longer be a competitive asset in competition among banks for accounts of large depositors. Competition might rather be intensified in the service fields. It is conceivable that service competition might prove so costly as to influence banks into much riskier credit policies. With a significant expansion in deposit coverage it is therefore argued that the scale of bank supervision would need to be materially enlarged.

Lastly, extension of deposit insurance is sometimes opposed on the grounds that it is not needed because the banking reforms during and since the mid-1930's, legislative and otherwise, have largely corrected weaknesses in the banking system which engendered depositor loss and depositor panic in the past. Two fundamental reforms in banking practice illustrate specifically lessons learned from the experiences in the last depression which have been used to strengthen the banking system against future difficulties. An agreement between bank supervisory agencies in 1938 represents a change in the concept of appraising bank assets from a basis of liquidating value to a going-concern basis of value.

For example, high-grade bonds are valued at the lower of book or amortized cost and loans are classified only on the basis of some question in regard to payment. Under this arrangement bank supervision should help to prevent forced liquidation of assets rather than contribute to such liquidation. A second major improvement in banking practice has been the growing tendency under the prodding of supervisory authorities in establishment of adequate reserves against losses. This trend was greatly stimulated by the recent ruling of the Bureau of Internal Revenue (mimeograph 6209) under which banks are permitted to establish such reserves out of income for tax purposes. The authority given to the Federal Reserve to lend on any sound bank assets is also cited as a measure that vastly increases the capacity of the banking system to meet demands for funds made on it. It is one point of view that because of these banking reforms deposit insurance is no longer needed. However, the existing insurance plan is generally recognized as being a part of the warp and woof of our present day banking and elimination is not usually recommended by those holding this view. But neither is expansion considered necessarily desirable.1

As to full deposit insurance coverage, the case rests basically on the thesis that the primary function of deposit insurance is to preserve stability in the money supply and thus to contribute to general economic stability, and that the lessons of past financial crises show that extension of insurance to cover all deposits is essential to the full accomplishment of those objectives. With respect to this thesis, the following points are made, which are developed in subsequent paragraphs:

1. More than half of the dollar amount of all individual and business depositors are in noninsured accounts. Large rather than small depositors historically' have exerted the main pressure on banks' liquidity positions.

2. Many deposits of more than $5,000 are small business balances, loss of which would result in economic distress to individuals and the community.

3. Substantially full deposit coverage already is provided in actual practice, although the stabilizing value of this is not taken full advantage of.

4. Although reforms in banking and in the economy as a whole, supplemented by experience joined in the last depression, reduce the probability of another prolonged major depression, and the quality of bank assets and banking practices in general appear to be much better than in any previous period of modern banking

1 A somewhat different interpretation of the interrelationship between deposit insurance and the banking reforms of the 1930's is given in the following section.

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