Recommendation
The staff recommends that the Board maintain the existing Bank Insurance Fund (BIF) assessment rate schedule of 0 to 27 basis points (bp)¹ per year. per year. This rate schedule complies with the statutory requirements of the Federal Deposit Insurance Act for the Board to establish a risk-based assessment system and set assessments only to the extent necessary to maintain the BIF at the Designated Reserve Ratio (DRR) of 1.25 percent.

Summary
Staff believes that the BIF reserve ratio will remain above the DRR throughout the assessment period. Therefore, staff recommends maintaining the existing assessment rate schedule. Based on December 31, 2004 data and projected ranges for the relevant variables at December 31, 2005, this rate schedule would result in an average annual assessment rate of approximately 0.11 basis points (bp).

Staff has considered a range of plausible events that could produce significant movements in the BIF reserve ratio. Our methodology provides ranges for estimated insurance losses that are primarily based on estimated changes to the contingent liability for anticipated failures (contingent loss reserve), changes in interest income and the market value of available-for-sale (AFS) securities due to changes in interest rates, and growth in insured deposits.

Analysis
In setting assessment rates since the capitalization of the BIF, the Board has considered: (1) the probability and likely amount of loss to the fund posed by individual insured institutions; (2) the statutory requirement to maintain the fund at the DRR, currently 1.25 percent, and (3) all other relevant statutory provisions. ²

Projections for the BIF Reserve Ratio over the Next Assessment Period
Staff's best estimate for the BIF reserve ratio as of December 31, 2005 is 1.26 percent. The lower and upper bounds of the likely range for the BIF reserve ratio as of December 31, 2005 are 1.20 percent and 1.31 percent, respectively. Although the lower bound of the estimated range is below the statutory requirement of 1.25 percent, staff believes that the ratio most likely will be closer to the best estimate of 1.26 percent.

The following is an analysis of the anticipated effect of changes in the fund balance and the rate of insured deposit growth on the projected reserve ratio as of December 31, 2005.

1. Fund Balance
Staff evaluates three significant inputs in estimating potential changes to the fund balance. First, staff estimates the impact of probable insurance losses, which are primarily losses from failed institutions. Second, staff estimates the amount of interest income that the fund will receive through December 31, 2005. Third, staff projects unrealized gains and losses on available-for-sale (AFS) securities through December 31, 2005.

A. Insurance Losses
Insurance losses primarily consist of two components: a contingent liability for anticipated failures (contingent loss reserve) and an allowance for losses on banks that have already failed. The Financial Risk Committee (FRC) recommends the amount of the contingent loss reserve each quarter. This recommendation represents the FRC's best estimate of "probable and estimable" BIF losses from potential bank failures, as required by generally accepted accounting principles. Actual results could differ from these estimates. As of December 31, 2004, the BIF loss reserve stood at $8.3 million, declining to $4.6 million as of March 31, 2005.

Staff has estimated a likely range of insurance losses based on projected changes in the contingent loss reserve for the period ending December 31, 2005. These projections are influenced by several factors, including: (1) the shifting of problem banks among different risk categories within the reserve, (2) the reduction in problem banks due to improved financial conditions, mergers, or failures, and (3) the addition of new problem banks. To capture the effects of these changes, staff uses a migration approach, which estimates the probabilities of banks entering into or leaving the contingent loss reserve as well as the probability of banks moving between loss reserve risk categories. These probabilities are based on the recent history of changes to the reserve. Other factors driving changes in the contingent loss reserve are changes in expected failure rates and changes in rates of loss in the event of failure. For purposes of estimating the contingent loss reserve, staff assumes that failure and loss rates remain constant through the period.

Based on consideration of the above factors, staff estimates that potential loss provisions for failures for the twelve months ending December 31, 2005 will range from -$1 million to $265 million, with a best estimate of $74 million. ³ Table 1 shows the range of potential loss provisions for failures as well as provisions for net losses/recoveries on resolution receivables, litigation losses, and other contingencies.

Table 1 Potential Provisions and Adjustments for Loss Allowances For the Twelve Months Ending December 31, 2005

	Low Estimate	Best Estimate	High Estimate
Provision Related to Future Failures (1)	$265 million	$74 million	-$1 million
Provision for Closed Banks'Net Recoveries (2)	$17 million	-$2 million	-$21 million
Other Provisions (3)	$17 million	$0	-$17 million
Potential Provision for Losses	$299 million	$72 million	-$39 million
*Figures may not add to totals due to rounding. Notes: (1) Includes provisions required to bring the contingent loss reserve to estimated December 31, 2005 levels after accounting for a) actual losses sustained in the first quarter of 2005 ($0), and b) estimated losses sustained through December 2005 ($7 million under the Best Estimate). Changes in the contingent loss reserve occur because of failures, mergers, improvement in problem institutions' conditions, deterioration of existing problem institutions, and new problem institutions. (2) Estimates include a first quarter 2005 decrease of $2 million in estimated losses on receivables from prior failures. Low and high estimates assume a range around the best estimate of -5% to +5% of the estimated net recovery value of bank resolution receivables totaling $375 million as of December 31, 2004. (3) Range is based on the standard deviation of changes in the year-end contingent liability for litigation losses and other contingent liabilities (e.g., representations, warranties, and asset securitization guaranties) for the period 1998 to 2004.

Staff believes that the range provided by the statistical migration analysis adequately represents the most likely range of additional provisions needed to cover insurance losses from future failures. However, the bounds of this range do not represent "best case" and "worst case" scenarios, and larger or smaller provisions could occur.

Banks in general appear to be well positioned to withstand considerable financial stress from unlikely economic shocks. Staff has considered economic stress events as they relate to specific risk concerns enumerated in the industry outlook contained in Tab 1. To determine the potential insurance fund implications of these concerns, staff has run several two-year stress event simulations based on data through year-end 2004 affecting institutions specializing in residential mortgages, subprime loans, commercial real estate mortgages, commercial and industrial loans, and consumer loans. The results of each simulation, which were derived from historical stress events, demonstrate that banks are well positioned to withstand a significant degree of financial adversity. In most cases, stress simulations resulted in fewer failed bank assets over a two-year horizon than simulations based on year-earlier data, and in no case did the results raise any significant concerns.

Therefore, staff believes that widespread deterioration in banking industry performance is unlikely in the next one-to-two years. However, if the stress conditions analyzed were to persist beyond a two-year horizon, it is possible that the effects on bank performance could be more severe. Furthermore, the historical experiences underlying the stress scenarios may be less applicable in the future. For example, greater "democratization" of credit, larger securitization volumes, and higher household debt levels in recent years could have altered the magnitude of stress on bank conditions from potential future problems in residential mortgage or commercial real estate sectors. Thus, conclusions drawn from stress scenario analyses should be treated with some degree of caution.

B. Interest Income and Unrealized Gains and Losses on AFS Securities
Staff relied upon expert forecasts as detailed in the Blue Chip Financial Forecasts to develop interest rate projections and analyze the potential effect of changes in interest rates on interest income and unrealized gains and losses on AFS securities. The forecasts defined as our "best estimate" were the consensus forecasts through the fourth quarter of 2005 as detailed in the March issue of the Blue Chip Financial Forecasts.Adopting the experts' consensus forecasts also allows for forecasted yield curves that change in shape over time. ⁴

Along with forecasting yield curves based upon the experts' forecasts, staff also calculated upper and lower bounds for interest rates using the historical differences between the experts' forecasts and the actual interest rates. These bounds vary over the assessment period and change in shape over time, as opposed to being parallel shifts in rates. The bounds are consistent with the notion that the projections represent the most likely scenarios and that the actual rates may be above or below the projections. In general, the projections indicate rising rates for the period under consideration. Charts showing the projected rates, upper bound, and lower bound are included as Appendix A to this case.

Table 2 shows projections for low, best, and high estimates for interest income and unrealized gains and losses on AFS securities using the forecast rates and upper and lower bounds.⁵ Because of the significant percentage of AFS securities held in the insurance fund portfolio at this time, when interest rates change, the magnitude of the resulting change in market value of these securities outweighs the effect of changes in interest income.

Table 2 Potential Interest Income and Unrealized Gains (Losses) on AFS Securities December 31, 2004 to December 31, 2005 ($ in millions)
	Low Estimate (1)	Best Estimate (1)	High Estimate (1)
Interest Income (2)	1,591	1,573	1,550
Unrealized Gain (Loss) on AFS Securities (2)	-456	-298	-157
Net Fund Contribution from Investment Activities	1,135	1,275	1,393
Notes: ((1) The Low Estimate is calculated using upper bound interest rates, the Best Estimate is calculated using the projected rates, and the High Estimate is calculated using the lower bound rates. Higher interest rates generally correspond to lower unrealized gains (higher unrealized losses) on AFS securities. On the other hand, because interest rates are generally higher in the Low Estimate scenario than in the other two, overall interest revenue is also higher in that scenario. However, the Low Estimate also assumes more failures and higher resolution outlays, which results in a smaller balance invested during the period and partially offsets the effect of higher interest rates on investment income. (2) Figures include actual investment income and unrealized gains/losses on AFS securities for the first quarter of 2005 and projected investment income and gains/losses for the remaining period through December 31, 2005.

Staff's best estimate reflects recent trends in market interest rates as well as expert forecasts. Since the Board last considered semiannual assessment rates, short-term Treasury yields have increased as the Federal Reserve raised the target for the federal funds rate by 100 basis points. Long-term Treasury yields also increased during the same period as the economy picked up steam. The rise in long-term yields fell short of that of short-term yields, leading to a further flattening of the yield curve. Experts continue to forecast a gradual increase in long-term Treasury yields, accompanied by a slightly sharper increase in short-term yields over the nine-month period ending in December 2005 as the economy continues to grow at a robust pace and inflationary concerns loom larger. Some depreciation in the value of AFS securities should be expected if interest rates rise at a pace similar to staff's best estimate. As the remaining maturity of the existing AFS portfolio shortens, previously identified unrealized gains will also dissipate. Over the longer term, higher yields on Treasury securities will boost overall interest earnings as securities reprice upward and as maturing securities are reinvested at higher rates.

C. Projected Fund Balance
Table 3 summarizes the effects on the fund balance of the low, best, and high estimates assumed for insurance losses, interest income, and unrealized gains and losses on AFS securities. The projection also assumes that the current assessment rate schedule will remain in effect through December 31, 2005.

Table 3 Projected Fund Balance (1) ($ in millions)

	Lower Bound	Best Estimate	Upper Bound
Assessments (2)	52	52	52
Interest Income (3)	1,591	1,573	1,550
Total Revenue	1,643	1,625	1,602
Operating Expenses (4)	843	843	843
Provision for Losses	299	72	-39
Total Expenses & Losses	1,141	915	803
Net Income	502	710	799
Unrealized Gain (Loss) on AFS Securities (3)	-456	-298	-157
Comprehensive Income (Loss) (5)	46	412	642
Fund Balance –12/31/04	34,787	34,787	34,787
Projected Fund Balance –12/31/05	34,833	35,199	35,429
Notes: (1) Projected income and expense figures are for the twelve months ending December 31, 2005. Figures may not sum exactly to totals due to rounding. (2) Assumes that the current assessment rate schedule remains in effect through December 31, 2005. (3) See notes to Table 2 for an explanation of changes in interest revenue and unrealized gains (losses) on AFS securities. (4) Projected operating expenses are based on the Board approved 2005 annual budget for ongoing operations of the FDIC Expenses are allocated across FDIC-managed funds based on the allocation of actual 2004 expenses for budgeted items. (5) Comprehensive Income is used instead of Net Income due to the magnitude of the change in market value of AFS securities that occurs with fluctuations in interest rates. See note (3) above.

2. Insured Deposits
Figure 1 shows that BIF-insured deposit growth rates since 1990, measured as of December of each year from the previous December, have been as high as 6.9 percent and as low as -2.1 percent. After declining in 1992, 1993, and 1994, BIF-insured deposits grew at annual rates between 0.8 percent and 3.8 percent in 1995-99. The pace of growth picked up in the next three years: 6.9 percent in 2000 and 4.8 percent both in 2001 and 2002. Improved stock market conditions helped to reduce growth to 1.3 percent in 2003. Deposit growth accelerated to over 4.5 percent in 2004. The high growth in insured deposits may result partly from an increase in short-term interest rates, primarily during the second half of the year, following monetary policy actions by the Federal Reserve. An increase in short-term interest rates relative to long-term rates makes short-term investment instruments such as bank deposits more attractive to investors.

     Figure 1