Carnegie-Rochester Conference Series on Public Policy 38 (1993) 1-34

North-Holland

Deposit insurance reform: a

functional approach*

Robert C. Mertont
Harvard University, Boston, MA 02163, U.S.A.

and
Zvi Bodie
Boston University, Boston, MA 02215, U.S.A.

Abstract

The current system of deposit insurance has a basic structural problem because
there is a mismatch between the deposits insured by the FDIC and the “opaque”
and illiquid bank loans used to collateralize those insured deposits. There may
have been, at one time, synergy created by using insured deposits as the primary
source to finance the commercial lending activities of banks, but we see no evidence
that such benefits, if any, exist in today’s financial system. There are, however,
significant costs for maintaining the current institutional structure. We conclude
that an efficient solution is for commercial lending to be financed by standard
instruments such as debt, preferred stock, and equity, and that deposit insurance
be limited to institutions or accounts that collateralize deposits with U.S. Treasury
bills or their equivalent.

1. Introduction

There is widespread agreement in the United States today that our system
of deposit insurance is a major economic problem, but there appears to be

*We thank the Carnegie-Rochester Conference participants, and especially George Ben-
ston, Mark Flannery, Ed Kane, George Kaufman, Robert King, Allan Meltzer, George
Pennacchi, and Charles Plosser, for their helpful comments.
t Correspondence to: Robert C. Merton, Harvard University, Morgan 397, Soldiers
Field, Boston, MA 02163.

0167-2231/93/$06.00 0 1993 - Elsevier Science Publishers B.V. All rights reserved.

no general consensus about the cause or the solution of the problem. Politi-
cians, journalists, and academics have offered many different opinions and
proposals. In this paper, we do not attempt to provide either a comprehen-
sive survey or critical review of all or even most of them. Instead, we apply a
particular analytical framework to arrive at a specific proposal for reform and
then use that framework to evaluate alternative proposals.’ To further focus
the analysis, we address deposit insurance only as it relates to commercial
banking in the United States.’
In discussions of deposit insurance, it is common practice to use the cost to
the U.S. taxpayer of bailing out the depositors of failed depository institutions
as the measure of the problem. The true cost to our society, however, is
the misallocation of investment and the unintended redistribution of income
and wealth caused by the current system. The current deposit-insurance
system, accounting rules, and regulatory procedures can encourage excessive
risk-taking. In some cases, they may even encourage fraud and abuse. Any
proposed cure must address those true social costs. Thus, a proposed solution
that leaves intact the incentives to misallocate and randomly redistribute
resources is no solution at all.
As is evident from the literature, there are two fundamentally different
perspectives and frameworks for analysis of deposit insurance and the bank-
ing system. The first takes as given the existing basic commercial-banking
institutional structure, and views the objective of public policy as helping
the institutions currently in place to survive and flourish. This institutional
perspective a.ppears to be the one generally taken by banking practitioners
and regulatory policymakers. 3 The alternative approach takes as given the
economic functions performed by commercial banks and deposit insurance
and asks what is the best institutional structure to perform those functions.
In contrast to the institutional perspective, this functional perspective does
not posit that existing institutions, whether operating or regulatory, should
necessarily be preserved as presently constituted.
As is the tradition in neoclassical economics generally, the functional
perspective treats the existence of households, their tastes, and their en-

1For a general overview of deposit-insurance reform, see Barth and Brumbaugh (1992),
Barth, Brumbaugh, and Litan (1992), and Brumbaugh (1993). The specific analytical
framework of our paper is developed in Merton (199213) Merton and Bodie (1992a,b and
c). In the banking literature, the analytical approaches of Black (1985), Black, Miller, and
Posner (1978), Gorton and Pennacchi (1992a), and Pierce (1991) are most closely aligned
with the development here.
2We have discussed elsewhere deposit insurance as it relates to thrifts. See Merton and
Bodie (1992b,c, Section 6). More generally, see J. Barth (1991) and Brumbaugh (1988).
3The thrust of policymaker thinking is often reflected in the titles given to government
reports. Thus, the U.S. Treasury entitled its February 1991 detailed proposals for financial
system reform, Modernizing the Financial System: Recommendations for Safer, More
Competitive Banks.

2
dowments as “givens,” exogenous to the economic system. However, this
tradition does not extend this fundamental right of continued existence to
other economic organizations such as business firms, markets, financial in-
stitutions, and government regulatory bodies. They are regarded as existing
primarily because of the functions they serve and are therefore endogenous to
the system. Thus, in the functional perspective, institutional form follows its
function. As part of an evolving process of change, it is thus to be expected
that old institutional forms will be superseded by new ones that perform the
underlying economic functions more efficiently.
We therefore begin our analysis by identifying the two core economic
functions performed by commercial banks.4 Commercial banks make loans
and guarantee loans to businesses, households, and governments.5 The types
of loans for which banks are specialists are those that are difficult to assess
without detailed, and often proprietary, information about the borrower.6
These borrowers are reluctant to reveal to the general public the information
which would be necessary for a direct public placement of the debt. The loans
taken by banks are risky and tend to require careful monitoring. Thus, bank
loans are relatively “opaque” assets. ’ They are not traded on the secondary
markets and therefore do not have observable prices. In most cases, proper
valuation of the loans requires nonpublic information about the borrower
so that market values cannot easily be inferred from the prices of traded
debt instruments with similar promised terms.8 Moreover, bank loans may
contain special terms and provisions not typically found in publicly-traded
instruments. With such a large potential for asymmetric information, it
follows almost a fortiori that loans of this type would be illiquid. Our measure
of liquidity is that the larger the bid-ask spread on a security, the less liquid

*As here, Diamond and Dybvig (1986) fecus on the functions of banks. They, however,
identify three core functions: (i) asset services, which is making loans; (ii) liability services,
which is transaction clearing, providing currency and other means of payment (checks, cash
cards); (iii) transformation services, which creates liquidity by buying illiquid loans and
issuing liquid deposits. The role of banks in liquidity creation is discussed in Section 3.
5According to the Federal Reserve, at the end of 1990 the breakdown of the loan
portfolio of U.S. commercial banks was: commercial and industrial loans 30%, real-estate
loans 37%, consumer loans 19%, all other 14%.
‘jFor discussion of the role of banks in the intermediation of asymmetric information,
see Diamond (1984), Fama (1985), and James (1987).
7We use the term “opaque” here in the sense developed in depth by Ross (1989).
“The trend in the recent past is for banks to invest in marketable debt instruments
including securitized loans of other banks. To the extent they do so, they are becoming less
like the institution we define as commercial banks. The bank assets that lend themselves
to being securitized are the ones that are least opaque, such as credit-card and automobile
loans. Corporate, commercial real-estate, and sovereign loans are not generally acceptable
for securitization and, therefore, tend to stay on the balance sheet of the firm. For an
extensive discussion of asset securitization, see the Fall 1988 issue of Journal of Applied
Corporate Finance.

3
is the security. A perfectly-liquid security trades with a zero bid-ask spread.
The other function of banks is to take deposits from customers. These
deposits are of two types: transaction deposits and savings deposits. Trans-
action deposits are, by definition, used by bank customers to make payments.
The function of a payments system is to facilitate the exchange of goods and
services at minimal cost. If two parties have agreed on the terms of trade
in a particular transaction (price, delivery date, etc.) and both have the
resources to carry out the trade, then the function of the payments system
is to efficiently implement the trade. In modern economies where individu-
als and especially business firms engage in many transactions every day, the
costs of acquiring information about the credit risk of every counterparty to
every transaction would be prohibitive. By having specialized intermediaries
whose function is to verify the ability of the parties to make good on their
transaction commitments, to credit the appropriate accounts, and to guar-
antee payment, enormous economies of scale in information-gathering and
transaction-processing can be achieved.
To perform this function efficiently the bank provides demand deposits
to customers which are free of default risk regardless of the size of the trans-
action. Customers then make payments by writing checks or making wire
transfers against those demand deposits. To achieve the primary goal of
an efficient payments system, therefore, transaction deposits should be com-
pletely free of default risk.g
There may have been at one time efficiency gains from using insured
deposits as the primary source to finance the commercial lending activities
of banks, but we believe there no longer are.” Of course, even if there are

‘There is some disagreement among economists on whether government deposit insur-

ance is the most efficient way of securing the payments system. However, there seems to
be widespread agreement among economists that, for a variety of reasons, the government
is ultimately the de faclo insurer of demand deposits. For a discussion of the different
points of view, see Flannery (1988, 1991) and Merton and Bodie (1992b,c).
“Gorton and Pennacchi (1992a) present several “agency-cost” arguments for using very
short-term debt to finance in large part those specialized institutions that make opaque
and illiquid loans. They show, however, that there is no need for this short-term debt to
take the form of insured demand deposits that are part of the payments system. Indeed,
we would argue that financing with insured deposits would defeat the agency purpose of
short-term debt because the holders of that debt would no longer have an incentive to
monitor the firm in making their decision whether to “roll over” the debt and continue to
finance the firm.
Benston and Kaufman (1988) argue that if the same institution that holds a customer’s
deposits also grants loans to that customer, economies of scale and scope can be achieved.
Black (1975) and Fama (1985) appear to make similar claims, although Black (1985)
later seems to reject such synergies. In these times, it is rare that either a business or
an individual carries all its financial accounts including credit cards with a single bank.
Moreover, we are unaware of any widespread practice to induce this behavior by offering
significantly better loan terms to those who would do so. If, however, such potential

4
no synergistic benefits to the linking of risky loans with demand deposits, if
there are also no dysfunctional aspects of that combination, one could argue
that maintaining the existing institutional structure is probably cost-efficient,
However, there are significant costs to maintaining the status quo. It is the
fundamental mismatch between bank demand-deposit liabilities insured by
the government and the illiquid, risky, and opaque loans collateralizing those
insured deposits that gives rise to the current deposit-insurance problem.
We are therefore led to agree with Black (1985), Litan (1987), Pierce
(1991), and Tobin (1985, 1987) that collateral be equal to 100% of transaction
deposits and that collateral should be restricted to U.S. Treasury bills or their
equivalent. ‘* This proposed solution to the deposit-insurance problem does
not require a “narrow-bank” structure that prohibits institutions which take
transactions deposits from engaging in other financial activities, including
risky lending. Indeed, under these collateral conditions, we see no danger to
the safety of deposits from depository firms offering other financial services.
Thus, our proposal does not eliminate any opportunities for economies of
scope or scale from “one-stop shopping” for consumers of financial services.
We believe that our proposal offers a minimal-cost structure for providing
default-free deposits without subsidies, either advertent or inadvertent. With
the recommended collateral arrangement, the cost of providing government
deposit insurance would be negligible. Currently, trading spreads in U.S.
Treasury bills are only a few basis points, and with the opportunity to net
deposits and withdrawals, depositories should have tiny transaction costs for
processing payments. With book-entry of the Treasury-security collateral
at the Federal Reserve, custodial costs for this arrangement should also be
minimal. Furthermore, firms that offer deposit services would require little
regulation, and there is no need for additional assurance capital.
The lending and loan-guarantee activities of banks, once separated from
insured deposits as the funding source, could then be carried on without
government restrictions designed to protect the Federal Deposit Insurance
Corporation (FDIC), which insures bank deposits. The financing of these
lending activities would presumably consist of some combination of common

efficiency gains are really there, our proposal for reform does not rule out lending and
deposit-taking activities within the same company, provided that the loans do not serve
as collateral for deposits.
In sum, we know of no study showing direct synergistic benefits from having risky loans
serve as the collateral for insured demand deposits.
“Kareken (1986) also proposes 100% U.S. Treasury collateral for deposits. However,
his proposal differs because it allows bonds of any maturity to be used for collateral,
and it does not permit depositories to engage in other financial activities. Accompanying
his paper are several discussions of his proposal. The idea of requiring interest-earning
obligations of the U.S. government as 100% reserves against bank demand deposits was
proposed by Friedman (1960). His proposal was, however, motivated by the objective of
achieving more effective control of the money supply.

5
and preferred stock, long-term and short-term debt, and convertible securi-
ties, as determined by competitive market forces. If, as some have suggested,
government intervention is required in the area of commercial lending to
overcome private-market failures, that intervention can surely be made more
efficient if it is not complicated by the existence of government-insured de-
mand deposits. ‘* Thus, by changing the institutional structure of commercial
banking-through separating banks’ lending and loan-guarantee activities
from their deposit-taking activities, it is possible to achieve potentially large
social benefits with no apparent offsetting costs.
A different approach to solving the deposit-insurance problem is to main-
tain the existing structure, but to substitute private insurance of bank de-
posits for government insurance. This could be accomplished in several
ways. One way is to directly substitute private deposit insurance for FDIC
insurance. l3 Another way is to impose high capital standards on banks. If
agency and tax costs make equity capital “too expensive,” then the govern-
ment could allow subordinated debt securities to count as bank capital.14
The subordinated creditors would then be the guarantors of the bank’s de-
posit liabilities.15 Ultimately, however, the government would still be the
de facto guarantor of the system. l6 Such a system could be made to work,

“Stiglitz (1991), for example, argues for government intervention to correct private
capital market failure arising from incomplete or asymmetric information. However, he
recognizes that the existence of deposit insurance gets in the way. His proposed solution
to the deposit-insurance problem is to increase bank capital requirements. We discuss
the problems with this solution in Section 2.3. Flannery (1991) presents a comprehensive
inventory and analysis of the rationale for government intervention in the banking system.
13See Ely (1990). Eng lish (this volume) documents the rather unsuccessful historical
experience with private deposit insurance in the United States. King (1983) discusses an
historical “experiment” that occurred in New York State during the period 1840-1860,
in which private insurance of demand deposits coexisted with 100% collateralization of
demand deposits with U.S. government securities. According to King, collateralization
worked much better than private deposit insurance in securing demand deposits against
bank defaults.
14See Benston (1992).
15Any time a loan is made, an implicit guarantee of that loan is involved. To see this,
consider the fundamental identity, which holds in both a functional and a valuation sense:

Risky Loan + Loan Guarantee c Default-Free Loan

Risky Loan - Default-Free Loan - Loan Guarantee
Thus, whenever lenders make dollar-denominated loans to anyone other than the United
States government, they are implicitly also selling loan guarantees. For further discussion,
see Merton and Bodie (1992b,c, Section 1).
16No matter how firm the government’s commitment to relying on private markets,
there is a problem of time inconsistency that limits their effectiveness. The essence of
the time-inconsistency problem with respect to deposit insurance is that, under certain
circumstances, it is socially optimal for the government to renege on its threat to allow
banks to fail. It is widely acknowledged that even in countries without formal deposit-

6
but it would be more costly than the proposed 100% default-free collateral
system, with no apparent offsetting benefits. To better understand the na-
ture of these costs, we now turn to a more detailed analysis of the guarantee
business.

2. Managing demand-deposit guarantees”

There are three basic methods available to any guarantor-whether private

or government-to manage its guarantee of bank demand deposits against
failure of the bank:
l Restrict the asset choice of the bank to ensure an upper boundary on the
riskiness of the bank’s assets.
l Monitor the value of the bank’s assets with the right to seize them if they
fall below a certain minimum capital standard. Holding fixed the premium
charged for the guarantee, the capital standards required for viability in-
crease with increases in the variance of the value of the bank’s assets or with
increases in the time between audits.
l Set a premium schedule for the guarantee. Ceteris Paribas, the premium
rate required for viability increases with increases in the variance of the value
of the bank’s assets or the time between audits.
Although not one of the three methods can work by itself, they can sub-
stitute for each other in terms of the degree of intensity of their use. Hence,
there is room for tradeoffs among them. A fundamental issue is that the
illiquid and opaque nature of the loans held by commercial banks and the
loan guarantees issued by them make it very costly for outsiders to monitor
them and to set appropriate capital standards or deposit-insurance premi-
ums. As noted, commercial and industrial loans and loan guarantees often
require the lender to have detailed knowledge of the borrowing firm’s op-
erations that cannot be made public. Consequently, those loans cannot be
easily securitized or otherwise resold. Their market values cannot therefore
be observed, or at least not observed frequently. In some cases, the market
prices of similar-type debt instruments such as junk bonds can be observed;
in other cases, there are no such cornparables. Market-value assessments of
bank loans are costly to make and typically have quite limited accuracy.

insurance schemes, the government is understood to stand behind demand deposits. The
government, therefore, is caught in a paradox of power. For market discipline to work, the
government must bind itself convincingly not to bail out banks that get into trouble. But
the government is too powerful not to intervene. Everyone knows that since government
makes the rules, it can change them, too. Indeed, only an incompetent government would
not intervene to stop a panic. But if t,he government will bail out depositors ~3:post, then
there is implicit insurance, even if there is no explicit insurance ez aale.
17This section is based on Merton and Bodie (1992b,c, Section 2).

7
2.1 Asset restrictions

As already discussed, in our view the most efficient method of insuring the
payments system against credit risk is to make sure that the collateral assets
of banks are closely matched in both value and risk characteristics to the
bank’s demand-deposit liabilities. In its strictest form, this proposal calls
for the FDIC to require insured banks to completely hedge their demand-
deposit liabilities by investing in the shortest-term U.S. Treasury securities
or their equivalent. Note that the asset restriction in this case covers both
the default-risk characteristics of the securities held by the insured bank and
their maturity. If a bank is allowed to invest in long-term bonds, the FDIC
can be subject to considerable interest-rate risk, even if the bonds are free of
default risk.l’
To the extent that the range of permitted assets backing demand deposits
is extended to include other securities, more resources would have to be put
into the monitoring process. To illustrate, consider the effect of allowing
banks to trade in derivative securities-financial futures, forward contracts,
options, and swaps. The opportunity to take positions in these securities
greatly enhances the ability of banks to quickly reduce their exposure to risk.
However, banks can just as easily use derivative securities to increase their
risk exposure. Even if a bank serves as a simple market-maker in derivatives,
it is not always an easy task to verify that the bank’s match-book is truly
matched, especially when there is credit risk among its counterparties.lg Al-
lowing banks to trade in derivatives therefore greatly complicates the ability
of outside monitors to determine the net exposure of a bank.

‘“This point is made by McCulloch (1986) in his discussion of Kareken’s (1986) proposed
reform of the banking system.
lgSince 1990 every big U.S. bank has been obliged to disclose certain information regard-
ing its positions in derivatives. Among this information is a measure called the “credit-risk
amount” or CRA, which is the maximum loss the bank would suffer if every counterparty
to every derivative contract defaulted. In terms of credit-risk exposure, the CRA measure
can be used in the same way as total net loans. According to Grant’s Interest Rale Ob-
server, April 10, 1992, p. 9, the net loans and CRAs for four money-center banks in 1991
were:

(in $ billions) Bankers Trust Chase Chemical Citicorp

Net Loans $15.2 $65.8 $81.0 $147.6
CRA 25.6 25.2 22.5 29.6

The riskiness of the assets represented by the CRA may be different from the riskiness
of the loans. Furthermore, the CRA overstates the default exposure because it does not
recognize the contractual right of the bank to net all its swap obligations (both gains and
losses) to a defaulting counterparty. These statistics nevertheless show that the poten-
tial credit-risk exposure from off-balance-sheet items warrants significant monitoring by a
guarantor.
2.2 Continuous surveillance with the right to seize collateral

If the FDIC has a covenant right to monitor continuously and seize assets,
shortfall losses can be minimized either by auditing the value of the assets
and seizing them before their value dips below the value of its insured de-
posits, or by making sure that the assets accepted as collateral always have
a value at least equal to the deposits. The surveillance and seizure system
employed by brokers in protecting themselves against default risk on the part
of their customers is an example of a system that relies almost entirely on
such monitoring. The futures and options exchanges in the United States
and throughout the world employ similar methods.20
A good example to illustrate how monitoring with continuous surveillance
can work effectively to protect the provider of a guarantee is the case of
broker margin loans. It is instructive, because the system functions with
only a minimal fee for the guarantee provided. When an investor opens a
margin account with a broker and borrows money to buy stocks or bonds, the
broker effectively is in the position of loan guarantor. For example, consider
an investor who invests $100,000 in stocks, borrowing half of the funds from
the broker. In practice, a broker typically borrows the funds that it lends to
investors from a bank (or the commercial paper market) and guarantees the
bank payment in full even if the investor defaults. The loan from the bank to
the broker is collateralized by all of the broker’s assets. These loans-both
the loan from the broker to the investor and from the bank to the broker-
are due on demand. The broker’s fee for providing its guarantee (that is,
for absorbing the default risk of the investor’s collateralized loan) and for
servicing the account is embodied in the spread between the interest rate it
charges the margin investor and the interest rate it pays to the bank.
As guarantors, brokers set two types of capital requirements: initial mar-
gin and maintenance margin. The initial margin requirement is the required
net worth of the investor’s account at the time the margin loan is made
and the securities purchased. 21 All the securities purchased by the margin
investor remain in the possession of the broker as collateral for the loan,
and the broker calculates the market value of these securities daily (and
sometimes more often on days when there is unusual volatility in price move-
ments). The net worth of the investor’s account is calculated as the market

“Miller (1990, Section 2.1.2), for example, describes how futures exchanges insure the
parties to a futures contract against contract-default risk by employing perfected collateral
that is marked to market on a daily basis. There is an additional layer of protection
against default risk built into the system in the form of a clearing house. All contracts are
formally between the buyer or seller and the exchange clearing house and thus carry that
institution’s guarantee. The same is true for exchange-traded options.
‘lAlthough the terms are set by individual brokers, the Federal Reserve sets regulatory
minimum levels of initial margin requirements.

9
value of the collateral less the debt to the broker. If the net worth of the
account falls below a prespecified fraction of the value of the collateral, called
the maintenance-margin ratio, the broker notifies the investor that he must
add additional equity capital to his account immediately. If the investor does
not respond to this margin call, the broker exercises its right to sell the se-
curities serving as collateral and pays off the loan out of the proceeds. The
investor receives the remainder, if any. Brokers find that this system offers
them substantial protection despite the fact that the prices of the securities
held by investors are often quite volatile.22
The key elements of this system of monitoring margin loans are: (1) the
guarantor has possession of the collateral; (2) the value of the collateral is
recomputed frequently at readily ascertainable market prices, and (3) the
guarantor has the right to automatically liquidate the collateral to pay off
the guaranteed liability if the ongoing capital requirement is violated. Each of
these elements is essential for the system to function properly. In particular,
frequent monitoring of the market value of the collateral would be pointless
if the broker did not have the right to seize and liquidate the collateral as
soon as the required maintenance-margin ratio was violated.
If the FDIC were to implement such a monitoring system for commercial
banks, the costs are likely to be significant. Effective monitoring requires
that collateral be valued at current market value. Although the concept of
marking to market is straightforward, its implementation can be complex
and costly. 23 If the collateral assets are traded in well-functioning organized
markets such as national stock exchanges and government-securities markets,
then reliable market values are readily observable, and marking to market is
a relatively low-cost process. However, for the kinds of assets held by banks,
estimates of market prices are subject to significant errors, and reaching
agreement on the proper mark-to-market procedure is considerably more
difficult.
These estimation errors impose risks on both the guarantor and the in-
sured bank. If the errors overstate values, the guarantor will not seize as
quickly as it should, and the proceeds realized from seizure will be less than
expected. If the errors understate the values, the bank will be seized a.nd liq-
uidated when it is actually solvent. Thus, a “conservative” valuation method

22Note that volatile assets, such as common stocks, can have small bid-ask spreads
and therefore be quite liquid. While illiquidity may be a barrier to the effective use of a
monitoring system, volatility by itself is not a problem.
231ndeed one of the main arguments used by representatives of the commercial banks
against maik-to-market accounting for bank assets is the high cost of implementation and
the poor quality of the valuation estimates. While they seem to view this as a reason to
abandon the concept of market-value accounting, we view it as demonstrating the high
cost of continuing to use traditional bank assets as the principal collateral for government-
guaranteed demand deposits.

10
from the perspective of one party to the system will be an “aggressive” val-
uation method from the perspective of the other party. Hence, the valuation
method should be unbiased. Protections for the parties from measurement
errors in the prices should be provided by other rules of the monitoring
system-such as the minimum size of the bank’s net worth before seizure is
permitted.
Because of the natural tension between the FDIC and the insured bank
over asset valuation, a key element of a mark-to-market system is that it
seeks to minimize the opportunities for manipulation. Especially if its assets
are traded infrequently, the bank has information about their true values
that is not costlessly available to other parties, including the guarantor. As
indicated, the bank’s incentives favor biased-high estimates of prices of its
assets and biased-low estimates of the prices of its liabilities. Thus, while the
bank may have information that could improve the accuracy of the valuation,
it may be optimal to neglect its inclusion in the mark-to-market estimates
if inclusion of this information allows too much discretion on the part of the
bank. That is, the accuracy of the valuation procedure is important, but just
as important is that the procedure be known, agreed upon by both parties
in advance, and difficult to manipulate. In sum, a proper mark-to-market
model is one that, specified ex ante, gives the best estimate of market price,
using verifiable data.
A word on book values in a monitoring system. It is sometimes sug-
gested that circumstances in which estimates of market prices are “noisy”
are ones that favor using book values-that is, amortized acquisition cost.
This seems to us to be a non-sequitur. We are not aware of scientific ev-
idence that book values are the best estimates of market prices, especially
for financial assets of the kind held by commercial banks.24 The evidence on
marketable junk bonds, which are reasonably close substitutes for many of
the types of loans held by banks, points in the opposite direction. Junk-bond
prices fluctuate substantially over time. It is therefore highly unlikely that
the best-fitting unbiased, nonmanipulatable model would produce values for
bank loans that remain virtually constant (around predictable amortized ac-
quisition cost) over time. Standard accounting rules for marking down book
values of assets, such as crea.ting a reserve for bad loans, are usually subject
to considerable management discretion, and their application often occurs
only after a considerable decline in value has already taken place.25 The

24M. Barth’s (1991) empirical findings are that “. market value accounting for invest-
ment securities is significant in explaining banks’ share prices. .” (p. 2).
“The FDIC’s standard practice, before the Deposit Insurance Reform Act of 1991, was
to close banks when their book-value capital-to-assets ratio reached zero. Nevertheless,
Hetzel (1991, p. 13) reports that for 1,000 banks which failed between 1985 and 1991, the
average loss ratio was 27% (the loss to the FDIC divided by the book value of the failed
bank’s assets). Thus, it would seem that the book values of assets provide biased-high

11
FDIC should therefore be reluctant to let an insured bank use book values
for illiquid assets. 26 There is a certain irony that the assets with the most
uncertainty about their values would be valued by a book system which pro-
duces almost no variation in price.
Apart from the fact that most loans in a bank’s portfolio have no observ-
able price, another difficulty in applying this model to commercial banks is
the illiquidity of the debt instruments that do have observable prices. The
relevant market price to be used in valuing the bank’s assets for these pur-
poses is the price at which they can be sold-the bid price. As long as assets
are marked to market at the bid price, the illiquidity of an asset serving as
collateral is not a problem for the guarantor. However, illiquid assets (which
by definition have a large bid-ask spread) are not suitable as collateral for
guarantees of demand deposits because the bunk is vulnerable to having the
asset seized and liquidated when the bid price falls, even if the average of the
bid and ask prices falls by a relatively small amount.27 The spread cost from
this “bid-ask bounce” is a deadweight loss to the collectivity of the bank and
the FDIC. Thus, if it is large and the chances of a violation are not negligible,
this form of handling guarantee risk is inefficient for illiquid assets.

2.3 Capital requirements

The measure of capital to be used as a trigger for seizure of assets should

include only the value of assets that can be realized in a liquidation, net
of any liquidation costs. To the extent that “going-concern” value or other
intangibles can be preserved in a liquidation, they should be included in
capital, Otherwise, they should be excluded.
If capital is large relative to the value of insured customer claims, then
premiums charged by the guarantor can be low, and surveillance can be
done less frequently. Since this saves surveillance costs, perhaps a lower-
cost solution for the FDIC would be to simply require insured banks to
have large amounts of capital in the form of either equity or subordina.ted
debt. However, this solution may be considerably less attractive upon closer
examination. The amount of capital required can be quite large, and it has
a nontrivial cost.

estimates of their market values, at least in financially distressed banks.

26As M. Barth (1991) interprets her empirical results, mark-to-market accounting for
only a subset of assets and liabilities of a bank may significantly distort its reported
financial position. Hence, all assets, not just the easily valued liquid ones, should be
marked to market.
27For example, suppose that an investor buys an illiquid asset at an ask price of $100
when the bid price is $50. Suppose that the price subsequently drops to $75 ask and $25
bid. If a margin call occurs and the asset is liquidated, the total loss in value is $100 -
$25 = $75, even though the average of the bid and ask price has declined by only $25.

12
 First, consider the amount of capital required. In the absence of FDIC
insurance of deposits, the amount of investor capital required to assure the
depositors freedom from default risk increases with increases in the volatility
of the underlying asset portfolio or the amount of time between audits. For
the kinds of assets held by commercial banks, the volatility can be quite
high. We know that for junk bonds, which are similar to some commercial
bank loans, the standard deviation of the percentage change in price is large,
from lo-30% per year. Portfolio diversification helps to reduce the risk,
but common factors across these bonds create positive covariances in their
returns, which limit the amount of risk reduction. Much the same point
holds for commercial real-estate loans. Uncertainty about the true market
value of the loans effectively makes the variance rate larger still. If careful
mark-to-market audits are infrequent, the capital required to make default
exposure negligible can easily exceed 20% of insured deposits.28
Moreover, setting appropriate capital requirements means that regulators
would have to make assessments of the riskiness of bank assets. This is very
difficult to do even if the assets were traded securities that are relatively
“transparent.” It is even a harder task for the opaque assets actually held by
banks. The costs-both private and social-of setting capital requirements
at the wrong level can be substantial. *’ In the case of the thrifts, we have
seen the result of setting them too low. But there is also a cost of setting
them too high. Furthermore, single-premium rates accurately set on some
notion of “average-asset risk” can nevertheless distort investment decisions
among accepted asset classes, often causing too much investment in higher-
risk assets and too little investment in lower-risk ones.
To see why bank capital provided for assurance purposes has a net cost
even if it is invested in assets that earn a fair market rate of return, consider
the equity-capital choice. As an empirical matter, financial intermediaries-
both insured and uninsured-do not typically have large amounts of equity
capital relative to the size of customer liabilities. One theoretical explanation
for this behavior is the agency and tax costs associated with equity financing
of any corporate enterprise. The very characteristic of the equity cushion

?Stiglitz (1991), perhaps somewhat casually, mentions a capital ratio of 20% as sufficient
to cover virtually all contingencies, even when loans cannot be reliably marked to market.
However, with asset volatility of even 10% per year, this ratio provides inadequate coverage
against only a “two-sigma” event, even if a full mark-to-market audit of all assets takes
place each year. The more general point is that an “adequate” capital ratio cannot be
determined without specifying both the volatility of the underlying assets’ returns and
the frequency of careful mark-to-market audits. Since the values of most traditional bank
assets are hard to assess, it is difficult to measure “true” returns on those assets, and hence
both their volatility and the cost of mark-to-market audits are high.
2gSetting capital requirements through government regulation has the same potentially
distorting effects on resource allocation as setting prices by regulation.

13
that makes it attractive to the guarantor of the bank-that shareholders
of the bank have no contractually specified claims to the firm’s current or
future cash flows-is the characteristic that creates a moral hazard for the
shareholders who provide that equity cushion.30 The resulting agency and
tax costs are thus the costs of using a large equity cushion as an alternative
to more frequent surveillance.
The agency and tax costs associated with using equity for assurance capi-
tal can be significantly reduced by the use of debt, because debt instruments
require the firm to make contractually specified payments in the future, and
those payments are tax-deductible for corporations. The use of subordinated
debt thus seems to offer a simultaneous lower-cost solution to the require-
ments of both the providers of capital and the FDIC.31
But there are problems with subordinated debt too. The use of sub-
ordinated debt effectively substitutes private guarantees for FDIC deposit
insurance. 32 Private subordinated creditors will then monitor banks in ad-
dition to (or instead of) government regulators. As long as the government
is ultimately responsible for the guarantees, private creditors will always
attempt to get “in front” of the government in case of a failure of the in-
sured bank. Debt instruments, such as corporate bonds, often offer investor-
creditors ways of getting their cash payments out of a troubled institution
before the FDIC can-high-coupon payments, call provisions, sinking funds,
and put-option provisions are examples. Furthermore, subordinated credi-
tors may become aware of the financial difficulties of an insured bank before
the FDIC, especially if the FDIC has reduced its surveillance activities to
save costs.
It may be in the interests of both shareholders and subordinated credi-
tors to use the bank’s “good assets” to satisfy the uninsured creditors while
leaving the “bad assets” for the FDIC. Thus, banks in financial distress will
tend to liquidate assets to meet interest and maturing principal payments
on subordinated debt to avoid immediate bankruptcy in the hope that con-
ditions will change. The assets liquidated will tend to be the ones with the
highest market-to-book value so as to minimize the impact of those liquida-
tions and payments on the bank’s (book-value) capital. This leaves the bank
with a disproportionate share of assets which tend to have low market-to-

30The only control shareholders have over management’s decisions (including the distri-
bution of future payments of dividends) is their right to elect management. See Jensen and
Meckling (1976) and Jensen (1986) for further discussion of the agency problem associated
with equity finance and corporate governance.
31Some propose that banks be required to maintain a minimum level of subordinated
debt as a way to impose market discipline on banks that undertake excessive risks in their
asset allocations. See Evanoff (1991), Keehn (1989), and Wall (1989).
32As explained in footnote 15, any debt instrument is equivalent to default-free debt
less a guarantee provided by the creditor.

14
book values. These “low-value” assets are the ones that will be available to
the FDIC to offset losses from coverage of deposits. Such “asset-stripping”
behavior is widely acknowledged to occur in cases of financial distress and
is very difficult to prevent. 33 Another difficulty in relying on subordinated
debt in the United States is the uncertainty surrounding actual priority of
FDIC claims in the event of financial distress. As we know from the work
of Tufano (1991), th e g eneral problem of determining seniority is not new.34
Bankruptcy judges have wide latitude in combining creditor classes to form
larger ones which are treated pari passv. In recent times, the courts have
interpreted the bankruptcy laws in ways that create considerable ambigu-
ity about the priority of the guarantor’s claims in the event of bankruptcy.
In two recent cases, the courts have decided that the claims of the Federal
agencies that have assumed the guaranteed deposit liabilities of failed thrifts
and the guaranteed annuities of bankrupt pension-plan sponsors are to be
treated pari passu with those of other creditors under Chapter 11 of the Fed-
eral bankruptcy code. 35 It is therefore important for the guarantor to monitor
the value of assets serving as collateral, and-in the event of a violation of
the required capital ratio-to seize them before the other liability-holders of
the firm cause the firm to seek bankruptcy-law protections. Thus, unless the
bankruptcy laws are changed to remedy the problem of settling the priority
of claims for firms in financial distress, high capital requirements in the form
of subordinated debt may not be a good substitute for aggressive monitoring
by the guarantor.
Finally, there is the issue of whether private parties would be willing to
provide banks with the assurance capital necessary to replace FDIC guar-
antees. Even with FDIC insurance, new capital has been flowing to the
institutions competing with banks rather than to banks.36 Under the cur-

?See Baldwin (1991) for evidence on the practice of asset-stripping in the thrift industry.
As reported in footnote 25, the average loss ratio of 27% by FDIC lends further empirical
support for this claim.
?Xrfano (1991) s h ows that over a hundred years ago, creditors of the railroads in the
United States were grappling with this issue. Some of the major financial innovations of
that period-preferred stock, income bonds, and voting trusts-were motivated primar-
ily by the need to find efficient ways to resolve financial distress without incurring the
deadweight losses associated with bankruptcy proceedings.
35The first is the case of the Resolution Trust Corporation against Oak ‘Dee Savings
Bank, and the second is the case of the Pension Benefit Guaranty Corporation against
LTV. Apparently, the FDIC has accepted the view that it does not have priority claim
over other bank creditors since it has asked Congress on more than one occasion to provide
legislation giving it seniority. Clearly, subordinated debt has little use as “cushion” capital
if it is not truly subordinated to the FDIC’s claims.
36Keeley (1990) pr esents evidence that bank stocks have been losing market value for
the past 20 years. He attributes this to increasing competition both within the banking
industry and with nonbank alternatives.

15
rent banking structure in the United States, a typical cost estimate to “break
even” is 200-400 basis points above the rate paid on deposits. In contrast, the
expenses of a money-market fund are about a tenth or 20-40 basis points per
year. In order to make banks more profitable and therefore better able to at-
tract new capital, some proponents of the high-capital-requirements approach
have suggested allowing banks to engage in a wider range of activities.37
However, as we have seen, greater latitude in asset choice for banks makes
monitoring them more costly. Moreover, from the functional perspective,
this expansion of activities only makes sense if there are gains in efficiency
(i.e., synergies) from having them combined in one institution without “fire
walls .”

2.4 Risk-based premiums

An alternative method of managing a viable guarantee business is to charge

risk-based premiums, as in the property and casualty insurance industry. A
precondition for the success of a system of risk-based premiums for deposit
insurance is that the FDIC be able to measure the values of assets and lia-
bilities and control the volatility of the value of the collateral-asset portfolio.
For risk-based premiums to work, asset variability need not be reduced to
zero, but it does have to be known (or at least bounded) and not subject to
significant unilateral change by the insured bank after the premium has been
set. If the insured bank can unilaterally change the variability of the asset
portfolio ez post, then the FDIC faces a problem of moral hazard.38
There is a substantial and sophisticated academic literature on applying
the methodology of contingent-claims pricing to deposit insurance.3g This
methodology offers a consistent way of determining risk-based premiums and

37This sounds remarkably similar to the proposals designed to “save” the thrifts in
the 1980s. Such expansion in permitted activities is likely to have greatly increased the
cost of the thrift bailout. For analysis of this point with respect to thrifts, see Barth,
Bartholomew, and Bradley (1990) and Merton and Bodie (1992b,c, Section 6).
ssFor a discussion and analysis of this moral-hazard problem for guarantors, see Chan,
Greenbaum, and Thakor (1992) and Merton (1990, Section 3.2). Indeed, much of the
academic literature on deposit insurance throughout the 1980s stressed this problem as
perhaps the most difficult one for the deposit insurer. Evanoff (1991), Keehn (1989),
and Wall (1989) propose using subordinated-debt requirements to help control this moral-
hazard problem. John, John, and Senbet (1991) design a convex tax structure to create
incentives for banks not to increase the volatility of their assets. Other structures that
create this same incentive can be found in Keeley (1990), Merton (1978), and Pennacchi
(1987a).
3gSee, for example, Acharya and Dreyfus (1989), Crouhy and Galai (1991), Cummins
(1988) Jones and Mason (1980), M arcus and Shaked (1984), Merton (1977, 1978, 1990,
1992a), Osborne and Mishra (1989), Pennacchi (1987a, 1987b), Bonn and Verma (1986),
Selby, Franks, and Karki (1988), Sharpe (1978), Sosin (1980), and Thomson (1987). See
also the entire September 1991 issue of the Journal of Banking and Finance.

16
relating them to a bank’s capital and asset composition. The essential insight
is that deposit insurance is isomorphic to a put option, with the bank’s
asset portfolio being the underlying security and the value of the insured
deposits corresponding to the exercise price. While we are not aware of
any country where the contingent-claims approach is currently used to set
deposit-insurance premiums, the U.S. Offi ce of Management and Budget has
been using it since 1991 to estimate the federal government’s liabilities due to
FDIC and other government guarantee programs.40 But, the “opaqueness” of
corporate and commercial real-estate loans presents considerable difficulty in
applying any type of valuation model for establishing appropriate risk-based
premiums.
In concluding this section, we note that recent legislation to protect tax-
payers against a repeat with the banks of the costly thrift bailout seems to
rely primarily on strengthening the capital base of insured depositories.41
This approach appears to be predicated on the objective of strengthening
the current structure of commercial banks. We see this as exemplifying the
“institutional” perspective of analysis that takes maintenance of the current
institutional structure as a primal postulate and seeks to make that given
structure work as well as it can. Applying a functional perspective, we found
a superior solution that requires changes in the institutional structure. How-
ever, absent such changes in the structure, the proposal to strengthen the
capital base is a major improvement over the current system, because it calls
for comprehensive market-value accounting, a strict monitoring system, and
establishment of risk-based premiums. Moreover, the Danish experience with
a system of mark-to-market accounting and strict enforcement of capital re-
quirements seems to work for them. 42 Danish banking authorities pursue
a very aggressive policy of seizing banks that violate capital standards and
reselling them to new owners while the bank’s equity still has significant
market value. Given the historical record on forbearance for both thrifts and
banks, there is reason to question whether such an aggressive seizure policy
to protect the FDIC would be tolerated in the United States.43

40See Office of Management and Budget, Budget of the U.S. Government for 1993,
Section 13, Identifying Long Term Obligations and Reducing Underwriting Risks.
41 We refer to the 1991 Deposit Insurance Reform Act. In May 1992, FDIC adopted new
rules that classify banks into one of three categories baaed on their capital-to-asset ratios.
The rules restrict the acquisition of brokered deposits and the interest rates paid by banks
classified in the lower two categories. FDIC also adopted risk-based insurance premiums
in a limited fashion.
42For further details about the Danish system, see the Appendix to this paper, Bernard,
Merton, and Palepu (1992), and Pozdena (1992).
43Moreover, the asset mix of Danish banks may lend itself to more effective mark-to-
market accounting than for the wider and more complex set of on- and off-balance-sheet
activities currently undertaken by U.S. commercial banks.

17
3. Functions of deposit insurance

If the collateralization reform proposed here were implemented, FDIC insur-

ance would cover 100% of transaction deposits but would have little economic
impact, since it would serve only as a backup to collateralization with U.S.
Treasury bills. Nevertheless, there is currently a widespread belief that de-
posit insurance is desirable for other reasons. Among those are:
l To encourage and enhance a safe and convenient form of investment for
small savers.
l To ensure an adequate and stable supply of credit to worthy borrowers who
would not otherwise have access to the nation’s supply of capital.
l To facilitate the creation of liquidity.
l To prevent a run on the banking system that might destabilize the
macroeconomy.
l To enhance the efficiency of the payments system.
We believe that only the last of the five requires deposit insurance for effi-
ciency. The other four are better served by alternative means. We offer a
brief analysis of each below.

3.1 Insurance of savings deposits

While politically popular, it is not clear that government insurance of sav-

ings accounts really adds to social value in today’s financial environment in
the United States. For households who demand completely default-free in-
struments, there are many other types of assets available in very convenient
forms. Shares in a U.S. Treasury money-market fund are one example. In-
deed, one of the great financial transformations of the last 20 years has been
the growth of money-market funds and their displacement of depository in-
stitutions as the repository of the liquid assets of households.
We suspect that the popularity of government-insured savings deposits
stems from the belief that somehow insured depositors are getting a bargain.
Given the competition that exists in this sector, it is hard to imagine that this
is the case, unless somehow the existence of government deposit insurance
has created a subsidy to insured depositors. A threat to the stability and
efficiency of the financial system is the fostering of the illusion that there is a
“free lunch” to be had through the mechanism of fractional-reserve banking
and FDIC insurance. Safety and liquidity of asset holdings carry a price, and
we see no reason for individuals desiring those features not to pay that price.
If public policy is to subsidize those services for the poor, deposit insurance
is not the least-cost way of doing it.
A common objection to proposals like the one presented here is that
demand deposits collateralized by Treasury bills would by necessity offer a
lower promised interest rate than that available on uninsured money-market

18
funds. As the story goes, since money-market funds appear to be as safe and
offer checking privileges, households will use them as transaction accounts.
The government will then be forced to guarantee them de facto. Because
the assets of these funds are not as restricted as those permitted in our
transaction-deposit accounts, these funds would have an unfair advantage.
We do not suggest forbidding mutual funds from offering check-writing
privileges. If a customer has shares in a mutual fund, it is a great conve-
nience to be able to use a check to order the sale of enough shares to make a
payment for some good or service. There is no need to prevent that, as long
as these mutual funds are marking the value of their assets to market. We
do, however, think that it is desirable to prevent money-market funds from
creating the illusion of perfect liquidity and complete safety of principal by
keeping a fixed price per share. This practice, which is now very common,
creates the illusion that the funds are offering an asset that is as risk-free and
as liquid as insured demand deposits, but at a higher yield. We see no pur-
pose for the practice of keeping the price per share fixed except to foster such
an illusion.44 Moreover, the assets of these funds, such as Al/PI-rated com-
mercial paper, are far less risky and opaque than the corporate, commercial
real-estate and sovereign loans that are the core assets of commercial banks.
Hence, by comparison to the status quo, proliferation of such substitutes for
truly default-free deposits is not a major problem.

3.2 Insuring an adequate supply of funds to small borrowers

There is a concern that without commercial banks which have access to

government deposit insurance, there would not be enough credit flowing to
households and nonfinancial businesses that do not have direct access to the
capital markets. Whether there was ever any merit to this argument, we
believe that in the current economic environment in the United States, there
is no longer any. The development of markets for “junk” bonds, securitized
loans (mortgages, automobile loans, trade receivables, etc.), and the growth
of nondepository finance companies now provide alternative sources of credit
to all sectors of the economy. There is every reason to believe that in a
relatively short period of time, these alternatives could completely replace
insured deposits as a financing source. Indeed, the loan and credit-evaluation
facilities that currently reside in banks could continue intact with a new
financing facility that does not use deposits. Some commercial banks, such
as J.P. Morgan and Bankers Trust, do not rely on insured deposits as a major
financing source. And, as already noted, the current trend in the commercial

44Alternatively, funds that call themselves “money market” and post a fixed ($1.00)
price per share could be greatly restricted as to the assets they can hold. An example
is the recent SEC restriction of such funds against holding commercial paper that is less
than top-rated (Al/PI).

19
banking industry is that banks are shifting their assets more and more into
marketable debt instruments that are much more liquid than the bank loans
of the past. As an example of just how rapidly the U.S. financial system can
shift the flow of funds from one institutional mechanism to another, consider
the change in the system of housing finance during the past fifteen years.45
None of these new institutional arrangements requires government deposit
insurance.

3.3 Facilitating transformation services: generalized liquidity creation

Diamond and Dybvig (1986) identify transformation services as one of the

three functions of banks. They oppose policy moves toward 100% reserve
banking because it “... would prevent banks from fulfilling their primary func-
tion of creating liquidity” (p. 57). It should be noted, however, that transfor-
mation services are performed and liquidity enhanced whenever a collection
of assets is “repackaged” and the resulting liabilities created have a smaller
bid-ask spread than the original assets. Thus, banks that hold illiquid corpo-
rate, commercial real-estate, and sovereign loans as assets and finance their
portfolios by issuing term-debt and equity which are traded in markets are
providing transformation services and adding to liquidity. Financing such as-
sets by issuing demand deposits is not the only means for increasing general
liquidity in the economy.
Conversely, banks that provide the specialized transformation service of
increasing the supply of (nearly) perfectly liquid assets by issuing insured
demand deposits need not invest the proceeds in highly illiquid assets with
large bid-ask spreads. Gorton and Pennacchi (1990, 1992a) make a case
for some economies of scope in jointly producing credit and perfect-liquidity
services, historically. However, they go on to provide theoretical analysis
and empirical evidence that such synergistic benefits no longer exist because
of technological progress and the associated development of new markets
and institutions. They also describe the asset characteristics which are best
for transformation into perfectly-liquid demand deposits: namely, a well-
diversified portfolio of (nearly) riskless assets which are easy to value and
have short maturities. These asset characteristics fit the profile of money-
market mutual funds, which Gorton and Pennacchi see as far more suited for
supporting transactions liquidity than the typical bank portfolio.
We agree with the broad points of their analysis, but we go even farther.
Demand deposits are both liquid and riskless. Liquidity and price uncer-
tainty are logically distinct properties of assets. A perfectly-liquid security

45As in the case of housing, pension funds that have little need for liquidity may become
an important alternative source of financing for traditional bank assets. See, for example,
the article, “Pension Funds as Yeast for Rising Companies,” in the Wall Skeet Journal,
April 21, 1992, p. A17.

20
trades with a zero bid-ask spread. Thus, shares of stock traded on securi-
ties exchanges can be highly liquid yet have considerable uncertainty about
temporal changes in price. 46 On the other hand, an individual’s claim to a
government pension may be completely riskless with no price uncertainty,
yet be totally illiquid. Government insurance is thus neither necessary nor
sufficient to ensure liquidity.
Under the current system of FDIC insurance, the government guarantees
both the temporal certainty of price and liquidity. However, the bank assets
that traditionally serve as collateral are both illiquid and subject to consid-
erable price-change uncertainty. This combination makes it very difficult for
the government guarantor to distinguish whether the “low” price obtainable
from an immediate liquidation of those collateral assets is due primarily to
illiquidity or to a change in their fundamental or intrinsic value.
Perhaps this structure was efficient in the past. However, the current
environment of low and secularly declining transaction costs for securitization
supports a hierarchical or “incremental” approach as an efficient means for
providing liquidity. Thus, highly illiquid and opaque assets can be financed
with stocks, bonds, and short-term debt instruments.47 Portfolios of those
securities, in turn, can be used to collateralize other claims having even
greater liquidity. To create securities with minimal price uncertainty, senior
short-term fixed-income claims could be issued against a portfolio of liquid
assets which serve as collateral. The value of those liquid collateral assets
would have to be much larger than the promised principal on the fixed-income
claims, so that promised payments could still be met even with large price
declines on the collateral assets.4s
This hierarchical approach uses the “next-nearest” asset for transforma-
tion to support perfectly-liquid and safe demand deposits. Thus, as ad-
vocated at the outset, the asset collateral ideally should be U.S. Treasury
bills. If the demand for highly liquid, riskless transaction deposits exceeds
the supply of U.S. T reasury bills, then add a well-diversified portfolio of
traded short-term, high-grade corporate debt such as Al/Pi-rated commer-
cial paper.4g

46By price in this context we mean the full price realizable from an orderly unrushed
sale of the stock.
47Ultimately the economic uncertainties associated with illiquid assets have to be borne
by someone. But the form in which they are borne can be made more liquid.
4”This approach differs from just having a large capital requirement on banks with their
current configuration of assets and liabilities because the assets here are liquid.
4gAs of December 1991, there were $590.4 billion of U.S. Treasury bills outstanding, and
the total of all interest-bearing marketable U.S. Treasury debt was $2,471.6 billion. The
approximate size of the U.S. commercial-paper market is $530.3 billion. Demand deposits
at commercial banks were $289.5 billion, and checkable deposits at other depository in-
stitutions $333.2 billion. Source: Federal Reserve Bnllelin, July 1992, Tables 1.21, 1.32,
1.41.

21
3.4 Preventing runs

The worst-case scenario is a banking panic. Depositors are content to leave

their deposits in banks as long as they are confident that their money is safe
and accessible. However, depositors know that the bank is holding illiquid
and risky assets as collateral for its obligation to depositors. If they believe
that they will not be able to get back the full value of their deposits, then
depositors will race to be first in line to withdraw their money. This forces
the bank into liquidating some of its risky assets. If the collateral assets are
illiquid, then being forced to liquidate them quickly means that the bank
will have to accept less than full value for them. If one bank does not have
sufficient funds to pay off its depositors, then “contagion” can set in, and
other banks are faced with a run. However, such a contagion problem occurs
for the banking system as a whole only if there is a flight to currency.50

The root cause of banking pa.nics is therefore the financing of illiquid bank
loans with demand deposits. 5* Government deposit insurance is very potent
medicine to solve the problem of bank runs. While it seems to work, deposit
insurance as a cure for banking panics has major drawbacks. It requires the
government to distinguish between “good” loans that a.re illiquid but will
pay off in full and “bad” loans that will not. Essentially, all the models that
show the welfare gains from eliminating panics (cf. Diamond and Dybvig,
1983) assume away this problem by positing that it is known for certain that
illiquid bank assets will realize their full promised value if only they are held
to maturity. In the real world, the benefits of eliminating panics must be
traded off against the prospect that the “true” economic value of the assets
is below the promised value of deposits (i.e., the panic is “justified”) and the
government is providing a “windfall” bailout. Surely, the opaque and illiquid
assets held by commercial banks a.re a particularly difficult group in making
that assessment. Hence, the case for welfare benefits from preventing runs is
greatly diluted if the insured institution holds assets of this type.52 Much the
same issue arises when the government intervenes by providing temporary
liquidity through the Federal Reserve discount window. The collateralized-
deposit proposal of this paper solves this problem by stopping the financing
of opaque, illiquid loans with insured demand deposits.

“The improbability of a flight to currency distinguishes the current situation from the
one that existed in the 1930s and contributed to the severity of the Great Depression. (cf.
Meltzer (1967) and Tobin (1987, pp. 168-9)).
51 For a discussion of the history of panics in the United States, see Calomiris and Gorton
(1991).
52Gorton and Pennacchi (1992b) fi n d no empirical evidence of contagion effects for non-
banks providing banking services.

22
3.5 Enhancing the eficiency of the payments system

As stated at the outset of this paper, the function of a payments system is to

facilitate the efficient exchange of goods and services. In the United States,
checks and wire transfers drawn on commercial banks are an important means
of payment. For large transactions, the seller will often call the bank in
advance to verify that the buyer has sufficient funds in his account to cover
the check. Sometimes, for smaller transactions, there are insufficient funds
in the check-writer’s account. The resultant “bad” checks are a nuisance to
those who receive them and, if it is unintentional, to those who write them.
This system of making payments is nevertheless quite efficient because
sellers do not have to spend much time or effort verifying information about
the credit-worthiness of buyers, and buyers do not have to spend much time
or effort proving their credit-worthiness to sellers. Both parties rely on the
bank to perform this verification and to guarantee payments up to the amount
in the buyer’s demand-deposit account. But what if the solvency of the bank
itself is in question ? Then a large part of the information-efficiency of this
system is lost.
To understand the efficiency gains from Federal insurance of transac-
tions deposits, it is helpful to draw a distinction between the “customers”
and the “investors” of a commercial bank that provides demand deposits.53
Customers who hold the bank’s demand-deposit liabilities are identified by
their strict preference to have the payoffs on their deposits as insensitive as
possible to the fortunes of the bank itself.54 By contrast, investors in the
liabilities (e.g., stocks or bonds) issued by the bank expect their returns to
be affected by the bank’s profits and losses. Indeed, the primary function of
the investors is to provide the risk capital which protects depositors against
default risk stemming from a mismatch between the bank’s assets and its
deposit liabilities. The investors are of course compensated for this service
by an appropriate expected return. Note that while the roles of “customers”
and “investors” are distinct, the same individual can be both a customer of
and an investor in a particular banking firm. Thus, we can be both a depos-
itor at a particular bank and also hold shares of its common stock as part of
our investment portfolio.55

53For a more complete discussion of the distinction between the “customers” and the
“investors” of a financial intermediary, see Merton and Bodie (1992b,c).
54As a formal example of this general point, consider an economy where there are pure
Arrow-Debreu securities for every state of the world. It is well-known that a complete
set of such securities permits Pareto-efficient allocations. If, however, the payoffs on such
securities were also contingent on the solvency of the issuer of the securities, then they
would lose their efficiency. See Merton (1992a, pp. 450-1, 463~7) for a more complete
discussion of this point.
“By definition, mutual banks are organized in such a way that all of their depositors are
also investors. However, t,he depositors of mutual banks are probably unaware that, they

23
 If demand deposits are subject to default risk on the part of the bank,
then sellers of goods seeking to verify the ability of buyers to make good on
their promises to pay would have to verify not only that the buyer has enough
money in his account but also that the bank in which the account is held is
solvent. Similarly, buyers who want the convenience of writing default-free
checks would have to monitor the solvency of the bank in which they have
their account. Uncertainty about the ability of the bank to make good on
its deposit liabilities thus creates “deadweight” losses.
The system of collateralized demand deposits that we advocate eliminates
this deadweight loss for all parties at minimal cost.56 The role of the FDIC
in this system is simply to confirm to the public that sufficient collateral is
there and that if it is not, then the FDIC will make good on the payment.

4. Conclusions

We are certainly not the first to arrive at our proposed solution to the deposit-
insurance problem in the United States. 57 However, we harbor the hope that
we have strengthened the ca.se for this solution by setting forth familiar a.r-
guments in a somewhat different way that perhaps highlights certain critical
issues. These are:
l There is a continuing need for the government to serve as the ultimate
insurer of the payments system. We believe that the least-cost method for
doing so is to restrict FDIC coverage to deposits that are backed 100% by
the shortest-term U.S. Treasury securities.
l If, contrary to our beliefs, one concludes that there is great value in pre-
serving the current institutional structure of banks, there are other ways
to improve the current system. Deposits that are collateralized by more
volatile assets can be guaranteed through a combination of monitoring and
risk-based premiums. The collateral assets used for this purpose must be
marked to market at their bid price, and capital standards must be strictly
enforced. However, these alternatives to the proposal of 100% U.S. Treasury-
backed deposits are more costly.
l A threat to the stability and efficiency of the financial system is the fos-
tering of the illusion that liquid and riskless deposits can be used to finance

are also investors. Indeed, if they believed that they were exposed to meaningful default
risk by virtue of holding their deposits at a mutual bank, they would probably hold their
transactions balances elsewhere.
56Gorton and Pennacchi (1992a) point out that deposits can be made riskless either by
the government guaranteeing the deposits’ value or by “guaranteeing” the asset value by
requiring the banks to hold U.S. Treasury bills. The latter way avoids the problem of
unintended transfers of wealth caused by mispriced deposit insurance.
57We echo the view of our good friend, Stanley Fischer, M.I.T., that in matters of public
policy, he would rather be right than original.

24
illiquid and risky assets at a small cost. The mechanism believed to provide
this “free lunch” is traditional fractional-reserve banking and FDIC insur-
ance. Belief in this illusion may explain the widespread popular support for
insurance of savings deposits. Safety and liquidity of asset holdings carry a
price, and if individuals demand these features, they should pay that price.
If public policy is to subsidize those services for the poor, deposit insurance
is not the least-cost way of doing it.
l Although there may have been at one time synergies from using insured
deposits as the primary means to finance the commercial lending activities of
banks, there no longer are. There may be efficiency gains in having the same
institution that takes deposits also engage in making loans and performing
other financial-service activities. Our proposed reforms do not rule this out.
With deposits backed 100% by U.S. Treasury securities held in a custodial
account at the Federal Reserve, there is no danger that the security of those
deposits would be jeopardized by other activities of the depository institu-
tion. Thus, under this proposal there is no need to have rules or laws (such
as the Glass-Steagall Act of 1933) restricting the other financial activities of
depository institutions.

We close with a few words about the feasibility of implementing our pro-
posal. The two functions traditionally performed by U.S. commercial banks
are increasingly being taken over by other financial intermediaries. Some
competitors, such as finance companies, compete with banks in making loans
without using deposits as a source of financing. Junk bonds have replaced
some bank loans. Further innovations currently under way suggest that pen-
sion funds may also serve as an alternative source for traditional bank-loan
customers. Indeed, as noted, even some commercial banks, such as J.P. Mor-
gan and Bankers Trust, do not rely on insured deposits as their principal
funding source. Thus, as with the major changes in the sources of funding
for housing during the 1980s) we see no major economic problem in shifting
the financing of bank assets to nondeposit sources during the 1990s. There
may, of course, be a political problem.

With respect to the deposit-taking function of banks, institutions such

as money-market funds compete with banks in providing safe and liquid
assets in a convenient form. In effect, money-market funds offer deposits
backed 100% with collateral that is not opaque and illiquid. U.S. Treasury-
bill money-market funds are close to the institutional structure for the trans-
actions deposits proposed here. Thus, implementation of our proposal is
feasible. The short-run transition costs for this proposal may exceed those
of some alternatives. However, as we have indicated, there are other inter-
mediate and long-run costs of choosing those alternatives. Hence, including
the present value of those longer-run cost differences, we believe that our
proposal is efficient.

25
 Under our proposal, the successor institutions to commercial banks are
likely to evolve from those banks. They will keep the same employees for
credit analysis and loan origination, and many will retain the same corporate
identity. 58 Banks with special expertise in originating and servicing corpo-
rate, commercial real-estate, and sovereign loans would continue to perform
those activities. The financing of those activities, however, would not come
from insured deposits. Large banks would expand their fund-raising through
issuing debt and equity securities. Smaller banks without direct access to
the capital markets could arrange financing through syndication with insti-
tutions that have such access. A number may find that the best solution is
to merge with other institutions. Given the extraordinarily high operating
expenses of the U.S. banking industry today, many observers agree that con-
solidation is necessary to reduce those costs and improve efficiency.5g Our
proposal would thus facilitate that consolidation.
However, the greatest potential efficiency gains from reforming deposit
insurance along the lines proposed here may well be the gains from reduced
regulation. While the successor institutions to commercial banks would still
have to comply with securities laws and other regulations that apply to all
financial-service firms, they would be free of the extra regulatory burdens
currently imposed on banks as a quid pro quo for deposit insurance and
special treatment by the Federal Reserve.”

5sFor example, Citibank has maintained essentially the same corporate identity through-
out this century even though it has performed quite different functions during that time
span.
5gMuch the same transition is taking place in the thrift industry.
601n an editorial, “Don’t Handcuff the Healthy Banks,” New York Times, May 17, 1992,
L.J. White refers to this quid pro quo with the banks as “...the Faustian bargain that has
protected them but also subjected them to regulated public utility treatment and extra
Costs.”

26
Appendix: The Danish System’
Denmark has used a mark-to-market accounting system combined with
strictly enforced capital requirements for banks for many years. While one
in eight Danish banks has failed within the last five years, all but one of the
failures were handled without explicit government financial assistance.
If a bank in Denmark falls below the required 8% capital ratio at the
end of any quarter, the government regulatory agency (the Danish Financial
Supervisory Authority) allows six months for the institution to raise new
capital (including equity and up to 40% subordinated debt). If, at the end
of six months, the bank is still not in compliance, the regulatory agency
immediately places the bank under new control, generally by arranging an
acquisition by a healthy bank. If an acquirer cannot be found, the bank is
closed.
Prior to 1988, Denmark had no formal deposit-insurance system. How-
ever, when the C&G Banken bank failed in 1987 and was closed, the Danish
government covered the resulting deficit to depositors (about $50 million).
Since that time, a deposit-insurance system has been established. However,
although the regulatory a.uthority has intervened in 23 cases of capital defi-
ciencies, there has not been one where government assistance was required.

‘See Bernard, Merton, and Palepu (1992) and Pozdena (1992)

27
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