Academic journal article Journal of Economics and Finance

FDICIA and Bank Failure Contagion: Evidence from the Two Failures of First City Bancorporation

Academic journal article Journal of Economics and Finance

FDICIA and Bank Failure Contagion: Evidence from the Two Failures of First City Bancorporation

Article excerpt

Abstract

We investigate contagion effects from the two failures of First City Bancorporation-the only large regional bank to fail before and after FDICIA. FDICIA imposes changes in the bank failure resolution process that expose uninsured depositors to substantially greater risk. We find that shocks to First City's weekly returns affect the conditional volatility of all but the most financially sound banks in the 1985-1987 period. This risk spillover effect is not evident in the period leading up to First City's 1992 failure, however, which suggests that the regulatory changes embodied in FDICIA have not contributed to a more risky banking system. (JEL G21, G28)

Introduction

The regulatory environment for dealing with problem and failing banks was changed dramatically by enactment of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in December 1991. Prior to this legislation, the FDIC generally resolved bank failure by finding an acquirer who would purchase the assets and assume the deposits of the failed institution (a so-called "purchase and assumption transaction"). The acquirer usually assumed all deposits (both insured and uninsured), thereby creating a de facto 100 percent deposit insurance system. Protection of uninsured deposits was most likely at the largest banks in the country, where, fearing contagion, federal regulators acted under the "too big to fail" doctrine (O'Hara and Shaw 1990). This policy protected uninsured depositors whenever possible, with exceptions occurring only in those few instances where the FDIC could not find an acquirer for the failed institution.1

FDICIA introduced two restrictions on regulatory actions that make it difficult, and in many cases impossible, for federal regulators to protect uninsured depositors. The first restriction-least cost resolution-requires the FDIC to choose the resolution alternative that produces the lowest cost to the Bank Insurance Fund. The cost of resolving a bank failure by transferring all deposits to a solvent institution must be compared with the cost of other resolution methods-including those that involve transfer of only the insured deposits. This change in regulatory policy has had a substantial impact on many uninsured depositors. The percentage of bank failures where all deposits were assumed or covered decreased from 83 percent in 1991 to 40 percent in 1996 (Benston and Kaufman 1997, p. 155). The second change in FDIC resolution procedures involved the "too-big-to-fail" policy. Beginning in 1995, and therefore not directly relevant to the two First City resolutions, the FDIC may not protect uninsured depositors unless the lack of protection threatens the stability of the banking system. An exception is possible only if (1) failure to protect uninsured depositors could produce serious economic or financial effects on the entire economy (i.e., systemic failure due to contagion) and (2) FDIC actions could reduce these effects. However, even in those cases in which the FDIC has the authority to invoke the too-big-to-fail doctrine, the cost of implementing this policy to the deposit insurance fund must be repaid through a special assessment on all insured institutions. It is therefore unlikely that "too big to fail" will be used in many cases subsequent to the enactment of FDICIA.

There are several reasons to believe that FDICIA may increase the possibility of bank contagion. To the extent that FDICIA does expose a larger fraction of depositors and nondeposit creditors to loss, the legislation may contribute to panic-type bank runs as well as information-type runs stemming from the information asymmetries between bank managers and depositors (Park 1991). This potential is obviously greater for larger banks which have a substantially higher fraction of their assets financed from noninsured sources. Moreover, the sharply-reduced flexibility of regulators in dealing with "too-big-to-fail" type failures may be perceived as destabilizing to the financial system. …

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