FROM THE OFFICE OF PUBLIC AFFAIRS

Madam Chairwoman, Congressman Vento, and Members of the Subcommittee, I appreciate this opportunity to present the Administration's views on the potential merger of the bank and thrift deposit insurance funds and related deposit insurance issues. We commend the Committee for giving this topic the attention its deserves.

The Administration supports merging the FDIC's Bank Insurance Fund (BIF) and Savings Association Insurance Fund (SAIF), as it has for several years. A merger of the two funds would produce a single, more diversified and less risky fund, diminishing the chances that a series of bank or thrift failures could deplete the funds and necessitate a call on taxpayers. We believe that now is the optimal time to merge the funds, when both are in good health and the banking and thrift industries are in strong condition. Let me divide my remarks into three parts: first, the benefits of merging the deposit insurance funds expeditiously; second, questions concerning the adequacy of the current designated reserve ratio of 1.25 percent; and third, the appropriateness of rebating insurance reserves at some level above 1.25 percent.

In 1995, the Treasury Department, the FDIC, and the Office of Thrift Supervision (OTS) jointly proposed a solution to problems with SAIF. At that time, SAIF had inadequate reserves and income. Its assessment base had been declining for several years, threatening SAIF's ability to meet its obligation to pay the interest on Financing Corporation (FICO) bonds issued in the late 1980s to replenish the former thrift deposit insurance fund. The prospect of a long-term, significant differential between SAIF and BIF premiums had given SAIF members strong incentives to shrink their SAIF-insured deposits, which only served to exacerbate SAIF's problems.

The Treasury-FDIC-OTS proposal had three key components: capitalization of SAIF; spreading of the FICO interest obligation across all insured depository institutions; and merger of BIF and SAIF.

Congress enacted the first two of these reforms in the Deposit Insurance Funds Act of 1996, which President Clinton signed into law as part of the Omnibus Appropriations legislation for Fiscal Year 1997.

• The Act required thrift institutions to capitalize SAIF by paying a special assessment on their deposits. This assessment raised SAIF's fund balance to the targeted level of 1.25 percent of insured deposits.
• The Act also spread the obligation for FICO interest costs across all FDIC-insured depository institutions, rather than on only SAIF-member savings associations. FICO interest payments were therefore supported by a large and growing assessment base, instead of a small and declining one.

The thrift special assessment and the spreading of FICO interest costs allowed subsequent SAIF premiums to decline and eliminated the premium disparity between BIF and SAIF. Banks and thrifts are thus currently subject to the same risk-based premium rates. Both SAIF and BIF now have fund balances in excess of the 1.25 percent designated reserve ratio: as of September 1999, SAIF's fund balance stood at 1.44 percent of insured deposits, while BIF's reserve ratio was 1.38 percent.

With both funds healthy, the Administration believes that now is the time to merge the deposit insurance funds. There are several reasons to support such a merger.

First, a merger of BIF and SAIF would strengthen the deposit insurance system because a larger, combined fund would benefit from greater diversification of risks than either the bank or thrift fund separately.

FDIC staff studies published last year found that banking industry consolidation has increased risks to BIF over the past decade. With an increasing percentage of industry assets spread over a decreasing number of banks, the probability that the failure of one of these large organizations would deplete BIF's resources has increased. According to the studies, the failure of a top 10 banking organization would carry a 12.5 percent chance of causing the fund to become insolvent.

Thus, a larger merged fund would provide a small but helpful offset to the increased risks that BIF currently faces from banking industry consolidation. Whereas the largest holder of BIF-insured deposits currently accounts for 8.7 percent of these deposits and the five largest holders of BIF-insured deposits account for 22.0 percent, those percentages would fall to 6.5 percent and 19.6 percent, respectively, in a merged fund.

SAIF has similar large-firm concentrations, although its risk diversification over the last decade has improved as some SAIF-insured thrifts and their deposits were purchased by commercial banks (so-called "Oakar" transactions). SAIF also faces product concentrations, as many of its members have significant holdings of residential mortgages, and geographic concentrations.

Second, it makes sense to merge the funds while the industry is strong and while the merger would not unfairly burden either BIF or SAIF members. Based on September 1999 data, a combined fund would have a reserve balance of $39.7 billion, and insured deposits of $2.84 trillion, for a reserve ratio of 1.40 percent. That would represent only a slight dilution for SAIF members (currently facing a reserve ratio of 1.44 percent), and a slight improvement for BIF members (whose fund currently has a 1.38 percent reserve ratio). Given the current designated reserve ratio and premium rates, neither thrifts nor banks would face higher costs as a result.

A third reason to merge BIF and SAIF is to guarantee that a premium disparity for the same product -- FDIC insurance -- will not arise again. Banks and thrifts with equivalent risks should pay the same premiums for their deposit insurance. Yet, as we have seen in the past, factors unique to one fund or the other might force FDIC in the future to set different risk-based premium rates for BIF and SAIF. The experience of the years leading up to the 1996 SAIF legislation demonstrates that depository institutions react to the emergence of such a differential by going to great lengths to find ways to reduce their reliance on the more expensive deposits. This activity represents a wasteful expenditure of resources, and a drain on industry efficiency and competitiveness.

Fourth, it is increasingly hard to maintain that SAIF is the deposit insurance fund for thrifts, while BIF insures banks. Both already are hybrid funds. Each insures the deposits of commercial banks, savings banks, and savings associations. As of September 1999, BIF-member banks accounted for over 37 percent of SAIF-insured deposits. And 31 percent of the total insured deposits of savings associations and savings banks are insured by BIF. A fund merger would simply recognize the commingling of the insurance funds that has already taken place and that is likely to continue.

Your invitation also asked for the Administration's views on the adequacy of the statutory designated reserve ratio, and the feasibility of imposing a cap on the insurance funds and rebating reserves above that level. I will discuss each issue in turn, but would like to start with one general observation. Any discussion about the appropriate level for the deposit insurance funds must come with a high level of humility and a clear recognition of the uncertainty of any predictions in this area. First, it is worth remembering that the thrift crisis - and in particular, the inability of deposit insurance reserves to cover losses from thrift failures - cost the taxpayers of this country over $125 billion. Although the banking industry is justifiably unhappy at the $793 million per year in FICO interest payments that it and the thrift industry make to finance the S&L cleanup, taxpayers currently make $2.3 billion in annual interest payments on REFCorp bonds and billions more on Treasury bonds issued for the same purpose. Second, it is also worth remembering that in 1981 the reserve ratio for the Bank Insurance Fund was at 1.24 percent, almost exactly at the fund's current designated reserve ratio. There were doubtless some in 1981 who may have believed that 1.24 percent was enough. Yet ten years later, in 1991, the reserve ratio was negative 0.36 percent.

This leads to your questions about the adequacy of the designated reserve ratio, currently at 1.25 percent of insured deposits, in light of the effects of prompt corrective action, national depositor preference, and the recently enacted financial modernization legislation.

The target of $1.25 in reserves for every $100 of insured deposits was established in the Financial Institutions Reform, Recovery, and Enforcement Act of 1989. Although its origins are somewhat obscure, we understand that a ratio of 1.25 percent was selected because it was considered generally in line with the FDIC's previous practice.

Congress and the regulators have in the past decade taken steps to reduce the likelihood of losses to the FDIC insurance funds. Nonetheless, as explained below, we believe it would be premature to conclude that these steps provide sufficient assurance to justify a rethinking of the current reserve ratio policy.

• Prompt corrective action, a system of capital-based supervision, was enacted as part of the FDIC Improvement Act of 1991 (FDICIA). It was intended to prevent regulatory forbearance by mandating increasingly stringent regulatory sanctions as an institution's capital declines, with closure of the institution required while the institution still has positive net worth. Although prompt corrective action holds the promise of lowering the number and severity of bank and thrift failures, it has not been tested during an economic downturn. We believe that more work needs to be done in evaluating the efficacy of prompt corrective action - in particular, whether capital is proving to be a leading or lagging indicator of bank condition.
• FDICIA also required the FDIC, when deciding how to resolve a depository institution facing default, to choose the method of resolution least costly to the deposit insurance fund, which generally would mean not protecting uninsured depositors and other creditors. Although there is an exception to the least-cost rule where systemic risk may be threatened, that exception cannot easily be invoked, and there are significant financial consequences for the industry if it is invoked.
• A law enacted in 1993 gave depositors a preference over general creditors in their claims against the estate of a failed bank. This could help the FDIC recover a greater portion of the funds it disburses. This benefit could be diminished, however, to the extent that the general creditors collateralize their claims or quickly withdraw their funds at the early signs of trouble.
• It may also be noted that interstate banking and expansion of bank powers, coupled with better risk management techniques, should help the industry diversify and thereby reduce risks to the deposit insurance funds. Yet as banking organizations take advantage of these new powers, new kinds of operational and other risks may also arise.

We hope and expect that the deposit insurance reforms of the early 1990s will provide added protection to the FDIC over the long term. But we believe that it would be premature to argue that they justify any change in reserve policy for the deposit insurance funds. Since these reforms were implemented, we have been in the longest economic expansion in the nation's history. We simply do not know what effect these reforms will have during a period of significant financial distress.

ndeed, we believe that industry consolidation may be a more significant factor affecting the deposit insurance funds' risk profile going forward. Using a model based on historical loss and failure rates, FDIC staff estimates that the probability of BIF insolvency, albeit small, has increased by more than half due to industry consolidation. It should be noted that the analysis shows that even a significant increase in the designated reserve ratio would not completely erase the increased concentration risk to BIF.

Madam Chairwoman, you asked for comment on an appropriate cap for a merged insurance fund, specifically inquiring whether a 1.5 percent cap would be appropriate. You also sought our views on rebates, considering the history and statutory authority of both the FDIC and NCUA. We consider these two issues to be linked, since imposing a maximum insurance fund size would implicitly require some sort of payment to insurance fund members if the maximum level were reached.

As we understand the current proposals for rebates, they would change current law to allow payments of rebates out of the fund's principal balance or interest income so long as the fund remained above a specified level, such as 1.5 percent. We oppose a structure that caps the insurance fund and mandates rebates of any "excess" reserves above that cap.

A rebate of "excess" reserves that could result from imposing a maximum insurance fund size would represent a break with past and current FDIC rebate structures:

• From 1950 through the 1980s, the law provided that FDIC pay rebates equal to a specified fraction (2/3 or 60 percent at various times) of its net assessment income. Net assessment income was the excess - if any -- of premiums paid over expenses and losses for a given period. The fund's principal balance and interest income were not available for rebates.
• Beginning in 1980, the amount of net assessment income rebated was tied to a range for the insurance fund reserve ratio, but growing losses forced FDIC to reduce and ultimately eliminate its rebates by the mid-1980s. In 1989, Congress prohibited rebates if the insurance fund was not at its designated reserve ratio, and abolished rebate authority in 1991.
• Congress restored rebates for BIF (but not for SAIF) in 1996. Healthy institutions can receive a "refund" of premiums paid for the assessment period only to the extent that the funds are not needed to meet the designated reserve ratio. Under its current authority, therefore, the FDIC pays no refunds since healthy institutions pay no premiums.

We oppose, for the following reasons, a change to current law that would allow banks and thrifts not only to pay no premiums but also to receive payments from the principal balance and interest income of the fund.

First, we do not find sufficient evidence for concluding that any insurance fund net worth above 1.5 percent represents "excess" capital that should be returned to insured institutions rather than retained by the insurer. We believe that those seeking to cap insurance fund reserves should bear the burden of proving that current fund net worth levels are excessive, and we are aware of no actuarial study reaching that conclusion. Indeed, at its current level of capitalization, BIF's reserves could be entirely depleted by the failure of the largest one or two BIF members. Even if merged with SAIF, the combined fund would not be able to withstand the failure of more than a few of the largest institutions. To be sure, under current law the FDIC would have the authority to replenish the fund through assessments on the industry. But such assessments would probably come at a time when the industry is least able to pay them, and could have a pro-cyclical economic effect. Thus, we believe that allowing the insurance funds to continue building up reserves through interest income during good economic times is good policy.

Second, rebates would exacerbate what is already a poor set of incentives around deposit insurance. FDICIA wisely required the FDIC to tie the deposit insurance premium paid by each insured depository institution to the risks that it poses to the fund. However, a provision to which the Administration objected in the 1996 SAIF legislation has significantly restricted the FDIC's ability to charge premiums. The FDIC may not charge premiums to institutions that are well capitalized and do not have "financial, operational, or compliance weaknesses ranging from moderately severe to unsatisfactory" if the premiums are not needed to maintain the designated reserve ratio. As a result, more than 90 percent of banks and thrifts currently pay no premiums at all. Reserves have continued to grow not because of premium income, but only because interest earned on holdings of Treasury securities has outpaced fund expenses and losses.

It is worth thinking about what the absence of insurance premiums means in practical terms: a well-capitalized institution with significant non-deposit liabilities can convert those liabilities to federally insured deposits without incurring any insurance premium charges at all. Indeed, there are reports that a major financial services company that owns insured depository institutions is planning to do exactly that with billions of dollars of liabilities. Put another way, such an institution can impose a large new contingent liability on the insurance fund, and ultimately the taxpayers, without paying compensation for it. The failure to charge such premiums creates clear incentives for risk taking.

Rebating funds in excess of some cap on insurance reserves could take bad incentives and make them perverse. In essence, the FDIC would be paying institutions for the risks that they impose on the insurance funds.

Third, banks and thrifts obtain insured deposit funding at low cost because depositors know that they are protected not only by the FDIC insurance funds, but also by the full faith and credit of the United States. As the ultimate guarantor of depositors' funds, taxpayers are providing every bank with a product of significant financial value. The Government does not explicitly charge for full faith and credit support to deposit insurance. Yet the subsidy value provided by this credit enhancement would likely rise if FDIC reserves are prevented from growing. This, too, would increase incentives for institution risk taking that could raise the Government's loss exposure.

Finally, allowing insurance fund reserves to rise in good economic times is simply sound financial policy that should benefit depository institutions and the FDIC. As I noted earlier, should a downturn occur, FDIC would have more reserves upon which to draw than if the fund were capped. This could help to postpone the date of any future increase in premiums, or reduce the magnitude of any such increase.

In asking for our views about rebates, you requested that we consider the history and statutory authority of the National Credit Union Administration (NCUA) to pay rebates to members.

Both the FDIC and NCUA designate a reserve target for their respective insurance funds. The FDIC targets a fund level that would meet the designated reserve ratio, currently 1.25 percent of insured deposits. Under certain conditions, FDIC may raise the designated reserve ratio. The NCUA must establish a target level for its Share Insurance Fund (SIF) reserves between 1.2 percent and 1.5 percent of insured credit union shares; the current target level is 1.3 percent. FDIC cannot charge premiums to healthy institutions if insurance fund reserves exceed 1.25 percent. NCUA cannot charge premiums if insurance fund reserves exceed 1.3 percent.

Nonetheless, there are significant differences between FDIC-insured institutions and credit unions in how they contribute to their respective insurance funds and account for those contributions:

• Contributions by Insured Institutions: FDIC sets premiums for banks and thrifts in amounts necessary to meet the designated reserve ratio. NCUA requires credit unions to meet the SIF target reserve level primarily by maintaining on deposit in the SIF an amount equal to 1 percent of their insured shares. (The amount that each credit union has on deposit is adjusted regularly to account for growth in its insured shares.) Credit unions may also be required to pay premiums to meet target reserves, depending on investment income, expenses, and losses.
• Accounting for Contributions to Insurance Funds: Banks and thrifts record the premiums that they pay as expenses. Credit unions expense any insurance premiums they may pay, but record the 1 percent deposit that they place with the NCUA as an asset on their books.
• Premium Rate Structure: FDIC premiums are tied to the risks of the insured institutions. NCUA may charge only flat-rate premiums based on credit unions' insured shares.
• Shortfalls in Insurance Funds: If an FDIC insurance fund balance falls below 1.25 percent of insured deposits, FDIC must charge sufficient premiums to eliminate the shortfall, but may allow insured institutions to replenish the fund over a period of up to 15 years. NCUA may charge premiums if SIF's reserves fall below 1.3 percent, and must charge premiums if reserves fall below 1.2 percent. If the fund falls below 1 percent, credit unions must expense a proportional amount of the 1 percent deposit, and have to replenish any shortfall from 1 percent generally within one year.

The NCUA makes distributions of reserves to credit unions if SIF reserves exceed the target level, and NCUA may not set the target reserve level above 1.5 percent. Credit unions receive distributions from SIF in proportion to their 1 percent deposit.

It is difficult to evaluate how the reserve cap and rebate structure might work if applied to the FDIC without considering other key elements of the credit union insurance fund structure.

Any perverse incentives caused by a rebate are diminished in the context of the NCUA structure, since even if rebates are paid, individual credit unions must make ongoing contributions to SIF in proportion to their insured share growth. Under the current FDIC structure, no such ongoing contributions are required.

If the FDIC were to adopt the NCUA's one percent deposit approach, including the ongoing contributions for institution growth, higher capital requirements for banks and thrifts would be necessary. The accounting treatment of the 1 percent deposit double counts a portion of the buffer to absorb losses - that is, the sum of industry net worth and insurance reserves. To compensate for this double counting, credit union net worth requirements were set at a level higher than that applicable to banks and thrifts.

But the credit union reserve cap and rebate structure must also be seen in the context of the structure and risk profile of the credit union industry. Industry consolidation does not pose nearly the same degree of risk to the credit union insurance fund as it does to the FDIC. The Treasury's report on credit unions found that the failure of the largest credit union, or three of the largest credit unions, would require credit unions to write-off only 20 percent of deposits at the SIF.

Your invitation asked whether we have related legislative or regulatory recommendations (apart from a fund merger). I spoke earlier of our concerns with the provisions of current law that greatly restrict the FDIC's ability to tie insurance premiums to risk. We believe that the FDIC should have more flexibility to improve the pricing of deposit insurance. Specifically, premium rates or the premium assessment base should be changed to reflect more accurately the FDIC's risk position by accounting for secured borrowings. Since the FDIC stands in line behind secured creditors in the resolution of a failed bank, the FDIC should be permitted to take account of a bank's secured liabilities in determining premiums. For example, a bank that replaces unsecured borrowing with Federal Home Loan Bank advances or repurchase agreements has effectively moved the FDIC to a lower position in claims on the bank's assets, yet the FDIC has received no compensation for the increased risk. As I mentioned earlier, one concern with the federal depositor preference law is that it gives a weak bank's creditors an incentive to secure their interest. Doing so gives those creditors a priority claim on the bank's assets (usually the best assets) while increasing the FDIC's expected losses should the bank fail.

In addition, we believe that Congress should rescind the Federal Home Loan Bank's so-called superlien on member assets. This statutory provision gives priority to a FHLBank's security interest in the assets of a failed bank, even if it has not perfected its security interest in such collateral. Consequently, the FHLBanks typically require a blanket lien over a large portion of a member's assets, essentially giving the FHLBanks a claim over those assets superior to that available to the FDIC. The superlien was instituted in 1987 in order to encourage the FHLBanks to continue lending to troubled thrifts - a form of forbearance. We see no reason to continue giving a government sponsored enterprise credit protection unavailable to any other creditor, especially since it could put the FDIC in a worse position.

In conclusion, we continue to support a merger of the FDIC's two insurance funds, which would strengthen the deposit insurance system by increasing its risk diversification and ensuring that premium disparities between institutions with equivalent risks do not arise again. We believe that Congress should proceed to merge the funds without incorporating other, more problematic changes to the deposit insurance system.