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Enacted at the depth of a banking crisis, theFederal Deposit Insurance Corporation Improve-ment Act of 1991 effectively turned the depositinsurance system into a privately funded, albeit stillmandatory and government-managed, system. Inthe 10 years since the FDICIA’s enactment, the newsystem has worked reasonably well to preserve thesafety and soundness of the banking system and toprotect taxpayers from funding losses to the FederalDeposit Insurance Corporation fund, for whichbanks are now responsible. Nevertheless, the FDIChas recently encouraged a reexamination of the cur-rent structure of the deposit insurance system toimprove its performance.Some of the changes proposed by the FDIC mayactually return the system to one in which the tax-payer is again at greater risk for funding bank losses.Chief among those changes is a measure, included ina number of bills now pending in Congress, thatwould allow the FDIC greater flexibility in the way itcharges insurance premiums on banks. In particular,it would alleviate the requirement to increase premi-ums as harshly and rapidly when losses drive thefund below the designated 1.25 percent reserve-to-insured-deposits ratio to replenish the fund withinone year. But that would increase the likelihood of the fund going and staying negative and increase theprobability of putting the taxpayer back on the hook.A second proposed change would increase themaximum coverage of $100,000 per account. That islikely to encourage some depositors to become lessconcerned about the financial health of their banksand banks to take on more risks, which wouldincrease the chances of bank losses and failures.Last, the FDIC would like to see insurance pre-miums reflect the riskiness of insured banks.Although it sounds good in theory, this is one task that bank regulators are ill-equipped to perform,because the appropriate risk also depends on therisks imposed by the regulators themselves whenthey fail to act in a consistent and efficient mannerin resolving troubled banks.An implicit government guarantee of banks willremain as long as the deposit insurance system isgovernment operated. For that reason, to reduce thatguarantee, insured banks should at least be given agreater voice in the management of the FDIC.Many of the proposed changes would dimin-ish market discipline and encourage regulatoryforbearance. Their adoption could inadvertentlylead to a reversion to the pre-1991 system of almost unlimited taxpayer liability.
FDIC Reform
 Don’t Put Taxpayers Back at Risk 
by George G. Kaufman
_____________________________________________________________________________________________________
George G. Kaufman is John Smith Professor of Banking and Finance, Loyola University, Chicago, and cochair of the Shadow Financial Regulatory Committee.
Executive Summary
No. 432April 16, 2002
 
Introduction
In August 2000 the Federal DepositInsurance Corporation issued a lengthy papertitled
 Deposit Insurance Options Paper 
,
1
whichwas intended to encourage public dialogue onpossible reforms in the deposit insurance sys-tem. That paper was followed by anotherstudy,
Keeping the Promise: Recommendations for  Deposit Insurance Reform
,
2
which presented theFDIC’s recommended changes. Largely as aresult of those two papers, Congress recentlybegan hearings to consider changes in the cur-rent structure of the deposit insurance systemin the United States.
3
In this paper, I review the past and currentstructures of deposit insurance in the UnitedStates and analyze the more importantchanges proposed in the FDIC papers and inthe subsequent bills introduced in Congress.Those changes deal mostly with three aspectsof the structure: how to fund insurance loss-es, the pricing of risk in insurance premiums,and setting account coverage ceilings.Federal government–sponsored depositinsurance was introduced in the UnitedStates in 1933, during the depth of the bank-ing crisis that accompanied the GreatDepression of the 1930s. The United Stateswas the second country to adopt nationaldeposit insurance, after Czechoslovakia.Between 1929 and 1933, the number of com-mercial banks in the United States declinedby more than 10,000—from more than25,000 to fewer than 15,000—mostly becauseof failure. In addition, there were widespreadfailures among savings and loan (S&L) asso-ciations, mutual savings banks, and otherfinancial institutions. Public confidence inthe ability of banks and thrift institutions torepay their deposits in full and on time waslow, and runs from deposits into currencywere widespread. The FDIC was establishedas part of the omnibus Banking (Glass-Steagall) Act of 1933 to offer full insuranceon small bank deposits and partial insuranceon larger deposits.
4
Since then, many majorand minor changes have been made in theinsurance system.
5
Most recently, the Federal DepositInsurance Corporation Improvement Act of 1991 introduced major changes in the sys-tem. Like the earlier Banking Act, the FDICIAwas enacted at the depth of a banking crisis,this time the crisis of the late 1980s and early1990s. By the end of that crisis, some 1,500commercial banks, which represented morethan 10 percent of the banking industry atthe start of the crisis, and some 1,200 S&Ls,or 25 percent of all the S&Ls in the country,had failed.
6
The costs of the S&L failuresexceeded the reserves of the then federalinsurer of those institutions, the FederalSavings and Loan Insurance Corporation, bysome $125 billion to $150 billion.
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That costrepresented the difference between the parvalue of the insured and other protecteddeposits and the lower market value of theassets at failed institutions and was paid bythe federal government—that is, by the U.S.taxpayer. Although the cost of the simultane-ous bank failures came close to depleting theFDIC’s reserves, it did not, and the FDIC didnot require any taxpayer funding.Since then, the banking industry has recov-ered strongly and few banks or thrift institu-tions have failed. Partially as a result, bothbankers and the general public have becomeless concerned about deposit insurance and lessfamiliar with its features, particularly thosenewly introduced by the FDICIA. This paper isin part intended to help increase awareness of both the current structure of deposit insuranceand the pros and cons of some of the moreimportant proposals for change raised in theFDIC options paper and elsewhere.
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The Current Structure
The post-FDICIA deposit insurance systemis basically a privately funded, government-managed system. The government’s liabilitythrough an implicit guarantee to pay at par atleast all insured deposit claims and possiblysome or all uninsured deposit claims is greatly
2
The post-FDICIAdeposit insurancesystem is basicallya privately fund-ed, government-managed system.
 
diminished from what it was in the pre-FDICIAera, during which the perceived governmentguarantee was of paramount importance.That change stems from the way in which loss-es to the FDIC (which now insures both banksand S&Ls) are now funded.
The Fund
Prior to the enactment of the FDICIA, thedeposit insurance fund was financed through afixed premium on banks of 8.33 basis pointsmeasured as a percentage of total domesticdeposits, regardless of the riskiness of banks’assets or the size of the insurance fund, althoughrebates were provided when the FDIC consid-ered the size of the fund to be appropriate. TheFDIC was allowed to build up the fund in antic-ipation of losses and, most important, was notrequired to increase premiums in the event of losses to the fund. The flat premiums encour-aged banks to engage in riskier behavior thanthey would otherwise, and the discretion theFDIC enjoyed meant that the implicit govern-ment guarantee was almost unlimited, as was thepotential taxpayer liability.The post-FDICIA structure dramaticallyreduces the number and amount of depositsthat are likely to be protected by the FDIC inthe case of bank failures. The FDICIA requiresthe FDIC to charge insured banks premiumsto build up a fund equivalent effectively to nomore and no less than 1.25 percent of insureddeposits and to maintain it at that ratio.
9
If,thereafter, the fund falls below that ratio,either because of losses resulting from the pro-tection of insured depositors at insolventinsured banks or from operating costs, theFDIC is required to increase premiums tobring the ratio back to the minimum percent-age within one year or to impose very high pre-miums the next year. In addition to revenuesfrom premiums, the FDIC receives incomefrom investing the monies in the fund in U.S.Treasury securities.Two further changes in the statutes haveaffected both the size and potential uses of the insurance fund. In 1993, the DepositorPreference Act subordinated deposits at for-eign branches of U.S. banks (on which insur-ance premiums are not assessed) and fundsat domestic branches of insured banks fromnonsecured nondeposit sources, such asFederal Reserve funds purchases and bondand note sales, to both deposits at domesticbranches and the FDIC. Thus, bank losses inexcess of the amount of the bank’s equitycapital are charged to those claimants beforethey are charged to other depositors atdomestic branches or the FDIC.
10
From theFDIC’s point of view, those subordinatedclaims serve as capital that buffers it fromlosses. In 1996, the Deposit Insurance FundsAct effectively prohibited the FDIC fromassessing premiums when the fund is above1.25 percent, except on “risky” banks—that is,banks that are not classified both “well-capi-talized” according to the prompt correctiveaction (PCA) criteria adopted by bank regula-tors under the FDICIA (see Table 1) and thatdo not have what is called a CAMELS rating(Capital, Assets, Management, Earnings,Liquidity, and [Market] Sensitivity)
11
of 1 or2, the two highest examination ratings givenby the federal bank regulators on a scale of 1to 5 (and which are therefore not in the topleft corner cell in Table 3).Those changes effectively converted the1.25 percent reserve ratio into a “hard target”that could not be either exceeded or fallenshort of. The FDIC may not raise premiumsin anticipation of future losses for which itdoes not reserve—for example the next cycli-cal downturn—and must raise premiums tofinance, within one year, any losses thatdiminish the fund below the 1.25 percent tar-get or increase the average premium on allbanks to a minimum of 23 basis points untilthat target is regained. Thus, the fund is basi-cally only a bookkeeping account. It cannotbe used to provide liquidity, except when thefund is above its designated value from earn-ings on investments and premiums on riskybanks and to finance temporary shortfalls inanticipation of revenues from requiredincreased premiums. Indeed, for most pur-poses, except for financing the buildup, tem-porary use to finance losses, and generatingearnings from investments, it does not mat-
3
The post-FDICIAstructure dramat-ically reduces thenumber andamount of deposits that arelikely to be pro-tected by theFDIC in the caseof bank failures.
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