The FDIC report released this week, “Keeping the Promise: Recommendations for Deposit Insurance Reform,” contains five interrelated recommendations for comprehensive reform:
- Merge the BIF and SAIF now.
- Eliminate the current statutory restriction on the FDIC’s ability to charge risk-based premiums to all institutions. Instead, the FDIC should charge all banks regular premiums based on risk, regardless of the fund’s size. (Note: under current law, when the fund ratio exceeds 1.25 percent of insured deposits, the FDIC cannot charge premiums to well-capitalized CAMELS 1 and 2-rated banks.)
- Eliminate sharp premium swings triggered when the reserves in the fund deviate from the statutorily designated reserve ratio. If the fund falls below a target level, premiums should increase gradually. If it grows above a target level, funds should be rebated gradually. (Note: under current law, when the fund reserve ratio falls below 1.25 percent, the FDIC must charge premiums sufficient to replenish the fund in one year, or charge a minimum of 23 cents.)
- Establish rebates to shrink the fund when it gets too big, and base rebates on past contributions to the fund, not on the current assessment base. (Note: This will ensure that institutions that haven’t contributed to the fund in the past don’t receive rebates.) The FDIC estimates that in an economy as relatively strong as we have today, more than 40 percent of the industry would receive more in rebates than they would pay in premiums.
- Index insurance coverage for inflation to maintain its real value. The right starting point for indexing is open to debate and should be determined by Congress.
The report stresses that the recommendations “are not a revenue-raising exercise” and “are not intended to increase the assessment burden” on the industry. Instead, they are designed “to spread that burden more evenly over time and more fairly across institutions....”
Pricing for Risk
The primary consideration in enhanced risk-based pricing is how to differentiate banks by risk to place them in different premium categories. The report suggests using a statistical model based on exam ratings, financial ratios and, for large banks, possibly certain market signals, to create a “scorecard” to slot banks into risk categories. The report includes an illustrative example of the way a scorecard system could work. The example uses CAMELS ratings and the following ratios to determine a score: equity to assets, net income to total assets, nonperforming loans to total assets, ORE to total assets, noncore funding to total assets, liquid assets to total assets, and asset growth rates. Other variables could be added to the mix. Details of exactly what factors should be included in a scorecard, and the relative scores of each factor, will require further analysis by the FDIC and discussion with the industry.
To illustrate how a scorecard system could work, the FDIC separated the 92 percent of institutions that are currently in the 1A premium category (zero premium) into 1A+, 1A, and 1A- categories, assigning them premiums of 1, 3 and 6 basis points respectively, before rebates. In the example, 43 percent of current 1A banks would remain in the lowest premium category (1A+) and about 25 percent each would be in the 1A and 1A- categories. In the example, premiums for the 2A through 3C categories would range from 12 to 40 basis points (currently 3 to 27 basis points). Where premiums would actually be set would depend on how much revenue the FDIC needed to cover the expected losses for each group on average (based on historical loss experience).
Taking the example one step further, the FDIC calculated that the average premium would be 3.5 basis points, raising $1.4 billion in revenue. Significantly, the report notes, the effective premium rate charged between 1950 and 1980 was about 3.5 basis points.
Eliminating Sharp Premium Swings
To smooth out premiums over the economic cycle, the report recommends allowing the funds to absorb some losses and adjusting premiums gradually. The fund target reserve ratio could be a range, or it could be fixed, as long as premiums were permitted to adjust gradually to return the fund to the target.
The report illustrates this with an example reserve ratio range of 1.15 to 1.35 percent. Within the range, risk-based premiums would be constant. If the ratio fell below the range, the FDIC would set a surcharge, for example, 30 percent of the difference between the reserve ratio and 1.15 percent. Conversely, if the ratio exceeded 1.35, the FDIC could rebate 30 percent of the difference between the ratio and 1.35 percent.
Using this example, the FDIC charted what the fund reserve ratio would be for the next ten years under three scenarios—no losses, moderate losses (equal to 25 percent of the losses suffered by the BIF in the last banking crisis) and high losses (100 percent of the losses suffered in the last banking crisis). Even under the no loss scenario, the fund never reaches 1.50 percent. In the moderate loss scenario, it fluctuates between about 1.35 and 1.45 percent. In the high loss scenario, it bottoms out at about .80 percent in year 6 and climbs back up to about 1.10 percent by year 10.
The FDIC also charted how premiums would fluctuate for 1A+ banks under the current premium scheme and under a revised system. Under the current premium scheme in a high loss scenario, premiums climb rapidly to 23 cents by the end of year 2, remain at 23 for several years, and then fall back to zero by year 8. By contrast, under the revised system, premiums would rise gradually from 1 basis point to about 10.5 basis points by year 5, then decrease gradually to about 2 basis points in year 10. For 1A- banks under this example, premiums would peak at 15.5 basis points as opposed to 23 basis points under the status quo.
Rebates to Adjust the Fund Size
If the FDIC charges premiums at all times, rebates are important to avoid enormous growth of the fund during good years, the report says. But rebates must be administered fairly. This means basing them on past contributions to the fund, and not on the current assessment base, so that new banks and rapidly growing banks that have paid no premiums for the past few years do not reap a windfall. For similar reasons, banks that paid higher premiums because they were in a higher risk category would be treated, for purposes of calculating their rebate, as if they had paid premiums in the lowest category.
In the best years, the rebate could result in the bank receiving a net payment from the FDIC. The FDIC estimates that in an economy as relatively strong as we have today, more than 40 percent of the industry would get back more in rebates than they would pay in premiums.
To illustrate how the rebate system would work, the report contrasts a $100 million 1A+ rated bank growing at an average rate, with a $1 billion 1A+ bank that was a fast-grower. Assuming the moderate loss rate scenario over 10 years and a 30% rebate of excess funds, the small bank would get a rebate in 6 out of the 10 years, for an aggregate net rebate of 4 basis points for the period. The $1 billion fast grower would only receive rebates in the last three years (after it had built up its past contributions), for an aggregate net premium of 2.1 basis points for the period.
Rapidly Growing Institutions
The report notes that the FDIC’s recommendations would address in several ways the concerns presented by rapidly growing institutions that dilute the reserve ratio yet pay nothing for deposit insurance. First, because premiums are less volatile, a decrease in the reserve ratio has a more gradual effect on net payments, so that rapid or new growth in a few institutions has less impact on other banks. Second, regular premiums for all banks means fast growers will pay increasingly larger assessments—and if the fast growth posed greater risk, they could be placed in a higher risk/higher premium category. Finally, with rebates based on past contributions, fast growers will pay higher net payments to the FDIC than established banks or slower growers.
Indexing Coverage For Inflation
The FDIC’s argument for indexing coverage to inflation is simple: “Deposit insurance is an important element of the government’s overall effort to promote public confidence in the banking system and, as such, it should not be allowed to erode in value.” Other important government programs, such as Social Security, Medicare and taxes, are indexed to maintain their real value, and federal deposit insurance should be treated in the same fashion, the report says.
The FDIC suggests using the Consumer Price Index as the inflation factor since it is widely understood and accepted and quickly available. However, which base year to use as a starting point is a question for Congress, the report says.
To avoid customer confusion and minimize additional operating expenses for banks (such as for retraining, new signs, etc.), the FDIC suggests that changes in coverage not be made too frequently and that coverage levels always be in round numbers (for example to the nearest $5,000). To illustrate how a system of regular increases in coverage based on the CPI could work,the report uses an example of indexing every five years if coverage has fallen below 80 percent of the previous level. Using the base year of 1974 when coverage was $40,000, coverage levels would have increased as follows: $60,000 in 1979, $82,000 in 1984, $103,000 in 1990, and $135,000 in 1999.
The Johnson/Hagel and Hefley bills introduced in Congress would index coverage for inflation every three years using 1980 as the base year, resulting in coverage of about $200,000 today.
The report mentions several other coverage issues that the FDIC believes merit further exploration, analysis and discussion among interested parties, including raising coverage levels for public (municipal) deposits, IRA’s or other retirement accounts.
All of the reforms proposed in the FDIC report would require statutory changes. The FDIC stresses that the examples in the report are illustrative only. They are designed to aid in understanding the implementation issues and how the recommendations might affect banks and the insurance fund. Ongoing discussion among the FDIC, the Congress, the industry and the public is needed to work out the best implementation of the reforms, the report notes.
The FDIC concludes by reiterating that the recommendations should be implemented as a package. “The proposed reforms are interrelated, so that picking and choosing could easily produce unintended consequences or make things worse,” the report says.
House Financial Services Committee Chairman Mike Oxley (R-Ohio) has already indicated his intention to hold hearings on FDIC reform proposals later this spring.