FDIC Losses in Bank Failures: Has FDICIA Made a Difference?

Article excerpt

Introduction and summary

Banks are generally failed and placed in receivership when the value of their assets declines below the value of their deposits and other debt, so that the value of their capital (net worth) becomes negative. The losses exceed the ability of the stockholders to absorb them. As a result, some of their creditors, and in the United States also the Federal Deposit Insurance Corporation (FDIC), which stands in the shoes of, at minimum, the insured depositors up to the insurance coverage ceiling, are likely to suffer losses. Because the FDIC is a federal government agency, if losses from bank failure resolutions are sufficiently high to exceed both the FDIC's reserves and its ability to collect additional revenues by levying sufficient premiums on insured banks to replenish the reserve fund, the losses may need to be paid by the government and thereby the taxpayers. Indeed, taxpayers were required to pay some $150 billion when losses incurred by the former insurer of deposits at savings and loan associations (S&Ls), the Federal Savings and Loan Insurance Corporation (FSLIC), in resolving the large number of failures in the S&L crisis of the 1980s exceeded its financial capacity to protect all insured deposits at these institutions against loss. Thus, the FDIC loss rate in resolutions is of concern to the uninsured depositors and other bank creditors who share in the loss with the FDIC, to the banks that pay insurance premiums, and to the taxpayers that are widely perceived to have backup liability. (1) It is in the best interest of all of these parties that the FDIC minimize its losses in failure resolutions.

Indeed, it is the losses from bank failures more than the bank failures themselves that are most damaging to both most stakeholders of the failed banks and the FDIC, so that it is more important to minimize this loss rate than the number of bank failures. Inefficient or unlucky banks that become insolvent should be permitted if not encouraged to exit, but with minimum losses.

In this article, I review both the causes of resolution losses to the FDIC and recent legislative and regulatory initiatives intended to reduce such losses, compute the loss rates experienced by the FDIC from 1980 through 2002, and compare and analyze the losses before and after the enactment of the FDIC Improvement Act (FDICIA) at year-end 1991, which, among other things, was intended to minimize such losses. I find that although the number of bank failures declined sharply after the implementation of FDICIA in 1993, the FDIC's loss rate increased significantly. This disturbing conclusion holds even after adjustment for changes in the size distribution of failed banks in the two periods. Only when the failed high-loss larger banks in the second period are also removed from the observations does the loss rate in the post-FDICIA period decline below that of the pre-FDICIA period. I conclude the article with speculation on why the FDIC's loss rate may have failed to decline and recommendations for enhancing the likelihood of loss reductions in the future.

These losses, however, are not necessarily the sole fault of the FDIC. Banks in the United States are declared insolvent and put into receivership or conservatorship under the FDIC by their chartering or primary federal regulatory agency, which is generally not the FDIC. Thus, the overall loss rate is in part determined by the embedded negative net worth of the bank at the time it is declared insolvent by these agencies and handed over to the FDIC. (2)

Causes of FDIC losses

Unlike most other firms, chartered banks in the United States are not failed and placed into receivership by the federal bankruptcy courts and are not subject to the federal bankruptcy code. (3) Rather, they are failed and placed in receivership (or conservatorship if the institution is to be kept operating by the FDIC on a temporary basis) by their chartering or primary federal regulatory agency and are subject to the provisions of the Federal Deposit Insurance Act (FDIA). …