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•BACKGROUND DOCUMENTS• Part II: Outreach Professor Kaufman said that he enjoyed the papers but wished that they had made stronger, bolder recommendations. He advised the authors to rely more on the literature and less on anecdotes, myths, and intuition. He noted that deposit insurance had a problem of time inconsistency. Its short-term advantages made it politically popular, while its long-term disadvantages tended to be overlooked. He asked whether the WGDI were dispensing political advice, economic advice or possibly both. He asserted also that some failures among inefficient or unlucky banks were necessary and runs were not necessarily a disaster—the papers should make that clear. He observed that moral hazard was not inherent in deposit insurance. He identified two types of moral hazard—excessive risk-taking by banks caused by under-pricing insurance coverage and by regulatory delay in resolving failed banks due to the wellknown principal-agent problem of supervisors failing in their duty to protect the public interest. He advocated higher capital for banks and expressed dismay over the issue paper’s concern that capital requirements could be set too high. He recommended that the authorities increase reserve requirements, which are easy to monitor, in some countries as an antidote to moral hazard facilitated by weak accounting systems that made observing solvency difficult. Professor Kaufman noted that economists were notoriously bad at handling questions that relate to transitioning from one position to another. He said that he had enjoyed the transition paper, but believed that it needed to justify the expressed preference for gradual transition and to present more details on the proper sequencing of the steps. He also called for more care in the papers’ use of technical terms. He concluded by asking why a blanket guarantee was always taken to be the answer in a crisis. Professor Pennacchi said that he appreciated the opportunity to discuss the papers, which provided some sensible guidelines. He proposed to focus on certain issues that he considered needed greater emphasis. He described how the financial safety net could be contained by placing less emphasis on restricting bank liabilities and more on controlling insured banks’ assets. For example, even a universal bank could pledge high quality assets to protect insured deposits against loss. Similarly, a financial holding company could restrict insured deposit taking to a subsidiary that held transparent assets. These asset constraints would eliminate the need for deposit protection. Then depositors could selfselect by placing their funds in a transparent subsidiary if they wanted safety. He wondered also whether designing the bank structure to rely more on private covenants could lead to less intrusive regulation. He noted that coverage limits could disadvantage a retirement fund that pooled the retirement funds of financially unsophisticated workers, such as a community of nuns, if the group were not otherwise accommodated. Professor Pennacchi supported the issue paper’s preference for making a transition gradual. He recommended that the pace of coverage reduction be made to coincide with improvements in the markets’ and the supervisors’ abilities to assess and monitor risks. He cautioned against setting a target for the deposit insurance fund that would drive the level at which premiums were set. The size of the fund reflected past mistakes, whereas premiums should be set to reflect future losses. He hoped that the private markets would take over part of the responsibility for insuring deposits and noted that coverage for deposits above the $100,000 insurance limit was already available from the private markets in the United States. In the question and answer period,Mr.Jack Tatom raised two issues. First, he opposed the proposal for a gradual removal of a blanket guarantee. He was concerned that a slow transition, in the continued presence of insolvent or weak banks, would provide additional opportunities for incurring losses. He asked whether granting full coverage in the first place were ever optimal. He considered it inadvisable to guarantee banks’ continued existence 170 Guidance for Developing Effective Deposit Insurance Systems: Volume II
•BACKGROUND DOCUMENTS• Part II: Outreach under blanket coverage in the face of admitted excess capacity. Second, he raised the possibility of limiting small depositors’ coverage across the banking system instead of setting the limit bankby-failed-bank as is commonly done. In response, Mr. Isoard observed that it would not be possible to close all banks when all were insolvent, so that a blanket guarantee was the best option. Mr. Tatom responded that insolvent banks need not be closed. Necessary and sound banking functions could be continued under new owners. Mr. Hanc noted that setting a system-wide coverage limit would make it difficult to estimate entitlements when a bank failed and slow the payout process. Such a change had been proposed in the United States and rejected under the first Bush Administration. Mr. Eisenbeis downplayed the importance of the size of the deposit insurance fund and claimed that government backing and ex post settling up by surviving banks would be sufficient where the government was financially credible. Professor Kaufman noted that funding for deposit insurance had become entirely private in the United States following the FDIC Improvement Act. Professor Pennacchi disagreed. He expressed his belief that the US government would provide financial aid in a situation where deposit insurance premiums rose so high as to threaten surviving banks. Professor Jackie So of Southern Illinois University pointed to the difficulty of continually monitoring a bank’s condition to identify and avoid sudden portfolio changes that could render it insolvent. Mr. Eisenbeis considered that the problem was broader, especially when it came to the desirability of marking the portfolio to market. Nevertheless, Mr. Eisenbeis was confident that markets could identify weak banks, such as LTCM in 1998, and that regulators now had the power to resolve them when their capital fell to two percent of assets. Panel III: Where Do We Go From Here Professor Kaufman moderated this panel, calling first on Mr. Hanc to explain what the Working Group had heard and then on Mr. Evanoff to summarize what the academics had been saying. Mr. Hanc wondered whether the day had revealed a large measure of agreement on potentially contentious issues despite the frustration expressed by some over the approach that the WGDI was using. Nevertheless, he had heard much good advice—do no harm and possibly do some good, be bold, and design a system—not just a set of spare parts. Unfortunately, he noted, the advice given was not always consistent. He observed that the discussants suggested that (1) market discipline should be given greater attention, (2) bank failures were not all bad, and (3) analysts must distinguish between runs on good banks and runs on bad banks. Mr. Evanoff observed that deposit insurance is an important, but not an easy topic, partly because it involved so many tradeoffs. He praised the WGDI for being willing to take on a difficult task. Concerning tradeoffs, for example, he observed that, while policymakers desired stability, it must be not achieved at the expense of stagnation: innovation must not be stifled. He recommended that the Working Group: (1) ground its recommendations more firmly in theoretical and empirical research; (2) find commonalities across countries on such things as infrastructure requirements, corporate governance, coverage limitations, closure policies, and ways to price risk; and (3) recall “the Lucas critique,” which notes that behavior may change in unexpected ways when policy changes. He noted that the issues were sufficiently important that help would be available to the group in implementing these recommendations if it requested such help. 171 Guidance for Developing Effective Deposit Insurance Systems: Volume II
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III Feedback
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FINANCIAL STABILITY FORUM Guidance
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