Outline

History of Establishment of the FDIC
Organizational Structure
Deposit Insurance
Money Sources
Regulatory Powers of the FDIC
Methods of Handling Failed Banks
Controversial Issues of the FDIC
Financial Crisis of 1980s
Back to Main Menu

From time to time a bank or other financial institution is unable to meet its obligations and pay its creditors, and unfortunately, it goes bankrupt. Before the Federal Deposit Insurance Corporation was established in 1934, the depositors of the failed bank had to wait several years for the assets of the bank to be liquidated (sold off) to get their funds back. Moreover, they would then get only a fraction of the funds deposited at the bank. Bank failures had been a serious problem for the depositor. Even during Roaring Twenties when the banking industry experienced the biggest growth the number of failures averaged 600 per year (Wood). The situation was even worse during the Great Depression when about 53 % of banks failed (Woelfel 86). Many people who had money in banks lost some or all of it when banks failed. However, the Great Depression is believed to not only have produced the bank crises but also to be one of its adverse results.

History of Establishment of the FDIC

As Milton Friedman pointed out in his book "A Monetary History of the United States," the largest reason for the Great Depression was the unprecedented decline in money supply, caused by the series of the bank panics in the period of 1931 to 1933. The banking system was very weak during this period and extremely vulnerable to even small deposit outflows. In turn, the reason for the bank panics was that depositors were uncertain about the stability of their bank in particular and the banking system in general. So if there were any hint to a bank problem, the reasonable reaction of the depositors' was to withdraw their deposits from the banking system. A run on a bank started, which usually terminated into a bank's failure. Moreover, banking panics tended to spread out to other banks, causing state-wide and even country-wide banking panics.

Thus, bank panics were not only dangerous to depositors themselves (lost bank deposits), but also to the economy as a whole, causing banking industry collapse and contraction in the money supply. That is what really happened with banking industry during the Great Depression. A number of bank panics were observed from 1930 to 1933, with the net result of the half of them terminating their existence. The financial system of the United States virtually collapsed. To stop this banking nightmare firm actions were required. In June of 1933, president Franklin D. Roosevelt and Congress made several changes. The Banking Act was signed by the President and the Federal Deposit Corporation was created to provide a federal government guarantee of deposits Insurance ("Internet Guide to the Government"). It was established for the first time in US history and designed to have not only ministerial but also important supervisory and examination powers which made it the third federal banking supervisory agency along with the Comptroller of the Currency and the Board of Governors of the Federal Reserve System.

Organizational Structure

The Federal Deposit Insurance Corporation is managed by a board of directors of three members. Two of them are appointed by the President with the advice and approval of Senate for terms of six years. The third member is the Comptroller of the Currency. According to the law, not more than two members shall belong to the same political party. The FDIC has its principal office located in Washington where executive officers work and about 1/4 of the total number of employees are stationed; and district offices located in Atlanta, Boston, Chicago, Dallas, Kansas City, Columbus, Madison, Memphis, Minneapolis, New York, Philadelphia, Richmond, St. Louis, and San Francisco. Largest division is the Division of Examination, with over tree-fourths of the Corporation's total employment (Woelfel 352).

Deposit Insurance

The Federal Deposit Insurance covers deposits of "every kind, including regular commercial deposits, time deposits, savings deposits, and trust funds awaiting investment" ("FDIC Homepage") and it does not make difference whether it is public or private deposit. The maximum limit for deposit insurance was set at $2500 per depositor per bank, when the organization was established in 1934 and was raised several times to the current limit of $100'000. The phrase "per depositor per bank" allows a person to avoid any default risk even if he has more then $100'000 distributing deposits among insured banks ("FDIC Homepage").

Money Sources

The FDIC is supposed to be a self-sustaining organization with net income coming from two main sources - assessments of insured banks and investment income.

Assessments of insured banks is annual insurance premium of 25.4 cents for each of $100 of deposits of its member banks. The rate was raised from 23 cents per $100 in 1992 (Woelfel 392). Originally it was only 1/12 of 1% of total insured deposit) (Golfeld 105). The FDIC pays operating expenses and adds to insurance reserves out of this premium. Moreover, legislation provides that the remaining portion of the premium earned each year after covering all insurance losses and operating expenses be returned to the insured banks as a credit against future assessments.

Income from investments in Government securities is the second source of FDIC's income. The insurance premiums are accumulated in the Deposit Insurance Fund which is invested in US Government obligations. The fund is available to cover future deposit insurance claims and related losses.

In comparison to the total deposits in the insured banks of $2 trillion the Federal Insurance Fund of $10 billion (1990) is quite small (Mishkin 233). It is understood that if major financial cataclysm occurs and a large number of financial institutions fail, the FDIC could not pay all insured deposits of those collapsed banks. But still the public believes in the system because the FDIC "is implicitly backed by the Fed and the U.S Treasury, both of which have the resources to handle extensive bank failure" (Mishkin 233). That means that if the FDIC runs out of its insurance reserves it can borrow money from the US Treasury and the Fed to pay out the insured deposits of the failed banks.

Regulatory Powers of the FDIC

Moreover, to eliminate even the need for applying for the help of the Treasury and the Federal Reserve System, the FDIC has the right to examine the member banks to ensure they are not engaged in activities and speculations that are too risky, and that they do not hold too risky assets that can lead to the bank failure and subsequent payout by the FDIC to depositors. In addition, the FDIC has the following powers in regards to the insured banks: to examine insured bank whenever it is necessary for insurance purposes; to terminate the insured status of the bank which continues to engage in unsafe and unsound practices after being noticed; to organize a merger, consolidation, or deposit assumption of the failing bank; to act as a receiver of any state or national bank placed in receivership.

Methods of Handling Failed Banks

But unfortunately the FDIC can not act proactively all the time and avoid all bank failures. Sometimes they occur and then the function of the Corporation is to compensate all the insured funds to the depositors of the failed bank. There are two primary methods the FDIC can employ to handle the failed bank. The first one is called "payoff method" - a bank in trouble is placed in receivership by a supervisory authority - the Comptroller of the Currency if it is a national bank, or the state authority if it is a state bank. Before placing a bank in receivership, the FDIC examines bank's records in order to determine the amount of the insured deposit liability. Then the corporation allows bank to fail and pays off insured deposits (up to $100, 000). After the liquidation of the bank the FDIC lines up with other creditors of the bank and gets paid its share of liquidated assets of the bank. When "payoff method" is used, the owners of the deposits over $100,000 limit usually receive over 90 cents per dollar, but the process can take several years to complete. This method is the least often used by the Federal Deposit Insurance Corporation (Mishkin 232).

Another way of dealing with troubled banks is to merge it with an insured bank instead of placing it into receivership. This method is called "merger approach", "deposit assumption method", or "purchase and assumption method." In this case all recorded deposit liabilities of a bank in trouble are assumed by another insured healthy bank, and the receiving bank get the assets of a closed bank and funds equal to the difference between the deposit liabilities and the acceptable assets. A willing merger partner assumes all the failed bank's deposits so that none of the depositors lose a penny. The FDIC can help a merger bank by providing it with subsidized loans or by buying some of the failed bank's weaker loans. This method insure not only insured deposits but also uninsured ones. In fact, about 95% of all deposits in troubled banks from 1934 to 1982 were assumed by a healthy and fully insured bank.

The creation of the Federal Deposit Insurance Corporation and its operations for the half of this century has been very successful by significantly reducing the number of the failed financial institutions since the Great Depression. The number of banks failed from 1934 to 1980 averaged only 10 per year (Mishkin 231). However, the creation of the FDIC brought not only bank system stability, but also some controversial issues and problems.

Controversial Issues of the FDIC

The first problem is insurance limit. Currently the maximum insured limit is $100'000, and the depositor with over $100'000 on their accounts are still exposed to default risk - that is, they will lose their money if the bank fails, so they still have the incentive to withdraw their money from the bank if they feel it is unsound. These withdrawals can be substantially larger since the deposits are large (over $100'000) and their withdrawals can lead even sound banks into a liquidity crisis. So many experts argue that this limit should be erased to cover all deposits. On the other hand, the FDIC thinks that this erodes "marketplace discipline" (Golfeld 106). As soon as depositors know that they are not going to lose money in case of a bank failure they are more likely to hold their deposits in a bank even if a bank is engaged in a highly risky activities. The point is that the risk of some loss encourages the largest depositors to control the current situation in a bank and put more stress on careful bank management.

Second problem of the FDIC is the method of setting the insurance premium paid to the FDIC. The controversial point is that premium is the percentage of total deposits not just insured. Many large banks consider this to be unfair. They believe they provide a subsidy for small banks because historically small banks have a higher failure rate and therefore they should pay higher risk premium. Large banks say that they are paying for insurance they are not getting.

Yet another problem is "too-big-too-fail" policy. The FDIC instituted such a policy to prevent the largest banks from failing by merging them with healthy ones so that no depositors will suffer a loss. One problem is that it destroys the already mentioned 'marketplace discipline." With "payoff method" large depositors will tend to control the bank conditions by pulling their money out when the risk is high, making the bank to engage in less risky operations. On the other hand, if a big bank is unlikely to fail there will be no incentive for large depositors to monitor the situation. The result is that big banks take on even greater risk making bank failure more likely. Another problem is that this policy is unfair with respect to small banks which large depositors will definitely suffer. In 1991 the FDIC Improvement Act changed this "too-big-to-fail" policy and it encourages the Corporation to resolve bank failures "in the least cost manner possible" (Woelfel 392).

Financial Crisis of 1980s

Theses internal controversial issues and problems become apparent in the 1980s when the number of failed financial institutions increased sharply.

For most of the period in which the system of federal deposit insurance has been in existence, banks faced limited competition for business. Entry was restricted, no interest was paid on demand deposits, and rates that could be paid on other deposits were controlled by Federal Reserve regulations. During the 1980s, however, many of these protections, which helped to reduce risks to banks and thus protect the deposit insurance system, were eliminated or greatly diminished by changed regulations, advances in technology, and other factors. Large, blue-chip companies, which were traditionally the major customer base for banks, began to raise much of the money needed to finance their operations directly from financial markets, bypassing banks. Banks also faced increasing competition from finance companies and other non-banks, and foreign banks. Facing increasing competition from other domestic and foreign industries with their traditional customer base shrinking, banks turned to alternative lending opportunities, such as loans to less-developed countries, loans to finance highly leveraged transactions, and loans for commercial real estate. These lending strategies carried greater risk of loss to both the insured institution and the insurance fund. Further, banks were still restricted from engaging in interstate banking activities, effectively preventing them from diversifying the risks in their loan portfolios. This left many banks vulnerable to adverse regional economic and market conditions. Meanwhile, flexible accounting standards contributed to the problem by enabling weak institutions to hide the extent of their problems until their losses had grown. In the second half of the 1980s, many of these institutions went broke: Between 1987 and 1991, 882 banks with assets totaling 151 billion failed ("FDIC Home Page").

In 1984, for the first time in its history insurance expenses exceeded premiums, but the shortage was funded through the FDIC's other sources of revenue, primarily investment income. This additional income was used to supplement insufficient insurance premiums during the next 3 years. However, in 1988, the rising level of bank failures and their increasing costs resulted in the FDIC incurring insurance expenses that exceeded all its revenue sources, resulting in the first net loss sustained by the FDIC in its history. Although legislation was enacted in 1990 to substantially increase the FDIC's authority to raise assessment rates, which the FDIC did, the rising tide of insurance losses continued to exceed the Fund's revenue sources. By December 31, 1991, these losses exhausted the Fund's reserves. The Federal Insurance Fund lost more than $25 billion in 4 years: from $18.3 billion in 1987 - its highest level ever - to $7 billion in the red as of December 1991. ("1997 Annual Report" 2).

The FDIC Improvement Act, enacted December 19, 1991 was to restructure and to reform the US financial industry. The major concern was to ensure safety and soundness of the banking system through accounting, corporate regulation requiring timely disclosure of internal control weaknesses. The Act recognized that capital and strong supervision are the first lines of defense against the bank failures. It requires to close a a failing bank with less than two percent of capital (Woelfel 392).

The depleted Bank Insurance Fund also needed to be rebuilt. The act increased the FDIC's borrowing authority from the Department of the Treasury from $5 billion to $ 30 billion to cover losses incurred from resolving troubled institutions. The FDIC was also required to develop and implement a recapitalization plan for the Bank Insurance Fund to increase the Fund's reserves to a designated ratio of 1.25 percent of insured deposits over a maximum of 15 years. The FDIC's borrowings from the Treasury are to be repaid by the industry and would be considered in recapitalization plans for the Fund ("1997 Annual Report" 2).

The timely implementation of the FDIC Improvement Act really helped to improve the safety and soundness of the banking system. The number of bank failures is back to normal: during 1996, only five banks with assets of $183 million failed; and only one bank failed during 1997 with total assets of $26 million. Bank Insurance Fund was fully recovered: the fund balance was raised to $28.3 billion in 1997 with the net income of $1,439 million for the year ("1997 Annual Report" 2).

Conclusion

Mankind was created by the God to live and overcome different obstacles and face various challenges. Whenever a problem occurs every person strives to put his or her best foot forward to be the winner not the loser. People devise various modes of problem solutions to secure losses caused by any problem. But, it would be very convenient for everyone if problems disappear immediately after "the key to open the door" is invented. Most of the problems tend to vanish for the first time and then emerge again in more frightening and complex form. It means that any problem should not be forgotten and must be tracked to prevent adverse consequences from happening in the future. Moreover, new and unique means of handling a particular problem are to be elaborated with each passing year. This comes from the fact that as humanity develops to be more complex, the relationships between people become more complicated, and the problems to be resolved get more tangled. Doesn't it follow that ways of problems resolution are to be even more sophisticated to handle them? The only answer is "Yes".

We can see the same picture in the FDIC's case. The Federal Deposit Insurance Corporation which was founded in early 1930's when the United Sates faced a threatening problem of country bank collapse is the example of means people create to master a problem. The FDIC has been in existence for 55 years now and it proved to be very successful. But it has not been working evenly and smoothly for the whole period. This happened because of changing environment and a great need for instantaneous reaction to different problems. The FDIC, when originally established, was a very successful mean of handling bank crisis and it seemed to work for a long period without drastic changes. But, recently the United States faced a huge number of bank failures again, which was the cause of new FDIC's policies and legal acts and regulations at the government level being created. The point here is that nobody can be sure of the present successful modes of insuring banking deposits to be valid in, say, for example, ten or fifteen years. They are to continually be reexamined and controlled for validity in accordance with current standards and, which is more important, with changing environment.

List of Works Cited