Mr. Chairman, I am Jeff L. Plagge, President and CEO of First National Bank of Waverly, Waverly, Iowa, and a member of the Government Relations Council of the American Bankers Association (ABA). I am pleased to be here today on behalf of the ABA. ABA brings together all elements of the banking community to best represent the interests of this rapidly changing industry. Its membership – which includes community, regional, and money center banks and holding companies, as well as savings institutions, trust companies, and savings banks – makes ABA the largest banking trade association in the country.
I would like to thank you, Mr. Chairman, for holding this hearing to examine some key issues related to the Federal Deposit Insurance Corporation (FDIC). We appreciate your long-held support of a strong banking and financial system, and in particular, your concern for community banks. We also greatly appreciate your leadership and your openness to working with the banking industry to develop reforms that enhance the deposit insurance system.
Assuring that the FDIC’s deposit insurance funds remain strong is of the utmost importance to the banking industry. Over the past decade, commercial banks and savings associations have gone to extraordinary lengths to rebuild the insurance funds, contributing $36.5 billion to ensure that the insurance funds are well capitalized. With the Bank Insurance Fund (BIF) exceeding $31 billion and the Savings Association Insurance Fund (SAIF) at nearly $11 billion as of March 2001 – representing over $42 billion in financial resources – it is safe to say that FDIC is extraordinarily healthy.
The outlook is also excellent. There have been few failures, and the interest income earned by BIF and SAIF (nearly $2.5 billion per year) is roughly three times the FDIC's cost of operation. As the current deposit growth rate moves back to the recent norm, as we expect it will, this interest income will likely continue to move the reserve ratio even further beyond the designated reserve ratio mandated by Congress. Moreover, the banking industry is extremely well capitalized, adequately reserved for potential losses, and profitable.
With the deposit insurance funds so strong, now is an appropriate time to consider how we might improve the overall system. To this end, the ABA has held extensive discussions with commercial banks and savings institutions, as well as with Members of Congress and their staffs and the FDIC, in order to facilitate the development of an approach that would both strengthen the system and be acceptable to a broad range of parties.
Just this weekend, this issue was discussed in detail at ABA’s Summer Meeting, which brings together our Board, Government Relations Council, the leadership of all the State Bankers Associations, and others. This testimony reflects the conclusions reached during that meeting.
The FDIC has done an excellent job developing an approach that addresses many of the key issues. While we do not agree with everything in the FDIC’s April 2001 report – and are particularly concerned about the possibility of increasing premiums – we believe it provides a basis for serious discussion.
The ABA has stated for the past year and a half that a bill to strengthen the FDIC is likely to be enacted only if an industry consensus in support of such legislation can be developed. As you will see, while some differences remain, the positions of the ABA, America’s Community Bankers and The Independent Community Bankers of America are very similar. Our three associations have agreed that we should discuss the issues together on an ongoing basis and work together to develop legislation that would have broad support.
I would add that while there is a general belief among most bankers that we should work with Congress to strengthen the FDIC, there is also deep concern that such legislation could evolve to increase banks’ costs or to become a vehicle for extraneous amendments. If that were to be the case, we have no doubt that support would quickly dissipate and turn to opposition. Indeed, our Summer Meeting discussion emphasized that the ABA will have to oppose any FDIC reform legislation that results in a increase in premiums when the insurance funds (or a merged fund) are above the 1.25 percent designated reserve ratio, as they are today. Fortunately, we also believe working together, we can see a consensus bill develop that can have broad bipartisan support.
In my testimony today, I would like to make several key points:
I would like to discuss these points more fully, and in the process, discuss specific issues.
I. Today’s System is Strong and Effective, But Improvements Could Be Made
For over 65 years, the deposit insurance system has assured depositors that their money is safe in banks. The financial strength of the FDIC funds is buttressed by strong laws and regulations including prompt corrective action, least cost resolution, risk-based capital, risk-based premiums, depositor preference, regular exams and audits, enhanced enforcement powers and civil money penalties. Many of these provisions were added in the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) and the FDIC Improvement Act of 1991 (FDICIA). Taken together, these provisions should reduce the number of bank failures, lower the costs of those that do fail, and ensure that the FDIC will be able to handle any contingency. Even more important is that the banking industry has an unfailing obligation – set in law – to meet the financial needs of the insurance fund.
Simply put, the system we have today is strong, well capitalized and poised to handle any challenges that it may encounter for decades to come. As with any system, there is room for improvement. We would propose three litmus tests for any reform: (1) it should strengthen and improve the deposit insurance system; (2) enhance the safety and soundness of the banking system; and (3) improve economic growth.
II. A Comprehensive Approach Is Required
The ABA firmly believes that any approach to reforming the FDIC should be done in a comprehensive manner. Since last year, support for a comprehensive approach has clearly grown. We are pleased that the FDIC’s proposal released in April 2001 is comprehensive and basically has put most of the relevant issues on the table for discussion. In this section of my testimony, I want to give you ABA’s perspective on what constitutes a comprehensive approach. Again, we recognize that any final bill may not cover in full all of the issues discussed below, but we respectfully suggest that all of them should be on the table.
The ABA believes consideration should be given to the concept of including the current insurance program elements of a mutual approach in which banks are provided with some type of ownership interest. Under such an approach, dividends would be paid based on the ownership interest. This approach will help address the issue of new and fast growing institutions paying no premiums, since such institutions will not have the same dividend stream. A great deal more work needs to be done to develop a specific proposal. We believe, however, that when the fund reaches a designated cap (discussed below), dividends should be paid to banks and savings institutions based on a measure of their historic payments to the FDIC. The FDIC says it can track such payments and develop such a system. A dividend system based on previous contributions is fair because it is the accumulated interest income on those very contributions that boosted the fund beyond the cap. Thus, this represents a return on the significant sacrifices that were made to more than fully capitalize the insurance funds.
Deposit Insurance Limit
As ABA stated last year, the current $100,000 insurance limit – set in 1980 – has lost over half its value when adjusted for inflation. As a consequence, it is more difficult, particularly for smaller institutions, to raise sufficient amounts of funds to meet loan demand in their communities. For many banks, a source of funding is the number one issue. Recent increases in loan-to-deposit ratios demonstrate that many community banks are searching for funds to support loan demand. In discussing this issue, three items deserve consideration: (1) indexing the insurance limit to account for inflation; (2) raising the insurance limit above the current $100,000; and (3) providing additional coverage to IRAs and other retirement accounts held at banks. Let me briefly discuss each in turn.
Indexing: There is general, although not unanimous, support within the banking industry for permanently indexing the level of deposit insurance coverage. Under an indexing system, the insurance limit would be automatically adjusted from time-to-time, based on changes in an appropriate index. These changes should be in level increments – e.g., five thousand dollars – to avoid consumer confusion. Without indexing, the insurance level constantly falls behind inflation, as Congress cannot be expected to regularly pass increases.
Base for Indexing: There has been a great deal of discussion within the banking industry, as well as in the Congress and the regulatory agencies, about the appropriate year to use as the base for beginning any inflation adjustment. For example, as the FDIC has pointed out, if the base chosen were 1980 (when the limit increased from $40,000 to $100,000), the insurance level would be approximately $200,000 today to account for inflation; if 1974 were chosen (when the limit was increased from $20,000 to $40,000), the new limit would be approximately $140,000.
In discussions with bankers over the last year on this topic, two questions emerged about increasing the coverage level: (1) what are the potential economic costs; and (2) how many new deposits might flow into the banking system? To help answer these questions, ABA hired Professor Mark Flannery of the University of Florida. Dr. Flannery’s study was extremely helpful in understanding the potential economic benefits and costs of various increases in the deposit insurance level.
The study concluded – based on research conducted separately with bankers, individuals and small business owners – that doubling coverage could result in net new deposits to the banking industry of between 4 percent and 13 percent of current domestic deposits, with the lower end of the range more likely, in Flannery’s opinion. Obviously, the amount of any increase would vary among individual banks, depending on their markets and business strategies. These hypothetical new deposits, plus the added protection that existing deposits (between $100,000 and $200,000) would receive, would lower the BIF-SAIF reserve ratio below the required 1.25 percent. This would eliminate the $3.2 billion cushion that exists today and would, under current law, require a 3-13 basis point assessment on all domestic deposits to return the ratio to 1.25 percent.
This study – the first attempt to assign real numbers to a complicated and theoretical concept – stimulated considerable discussion in the banking industry. Several points of view emerged: First, there are many bankers who strongly believe a significant increase to $200,000 is important to improve their access to funding and that the benefit would exceed the potential cost. Second, there are also many bankers who are very concerned about the loss of the current buffer above the 1.25 percent reserve ratio and the potential for premium increases that would accompany a significant increase of the insurance limit. Third, there are bankers who expressed concerns about the acceptability of such an increase to Members of Congress, the Treasury, the Federal Reserve, and others.
While there are differences of opinions in the industry, we believe that Congress should consider an increase in the current limit to the maximum possible that can be achieved without incurring significant costs that would outweigh the value of the increase. We appreciate your efforts, Mr. Chairman, to focus on this issue and the importance of attracting additional deposits into the banking industry to meet the credit needs of our communities. Of course, the bottom line is that we need to develop a comprehensive bill that addresses the key issues outlined in this statement that can also be enacted. We recognize that this is a controversial issue and therefore want to work with you to see what approach can be developed that can have the support necessary to be enacted.
Retirement Savings: The ABA believes Congress should also consider the possibility of a higher level of insurance for long-term savings vehicles, such as IRAs, Keoghs and any future private social security accounts if enacted. These are long-term investments that tend to grow considerably over time, frequently exceeding the current $100,000 limit. For example, at an interest rate of 6 percent, even an annual deposit of $2,000 in an IRA would grow with compounding to over $110,000 in 25 years. And because stock market volatility may be particularly worrisome to retirees, the security of insured deposits is very appealing. Moreover, these deposits represent a very important, stable funding source for bank lending.
A differential for retirement savings accounts is not a new concept. In fact, in 1978, Congress passed the Financial Institutions Regulatory and Interest Rate Act that provided IRA and Keogh accounts coverage up to $100,000 – two-and-a-half times the $40,000 limit that was in place at that time. The Senate Banking Committee Report on the Act supported the differential coverage in this way: "The committee believes that an individual should not have to fear for the safety of funds being saved for retirement purposes." Such a concern is as important today as it was then.
We also note that some of the concern, expressed by some Members of Congress and others, about a general increase in the $100,000 limit is based on the problem of "hot money" moving to weak institutions, as occurred in the 1980’s. However, this concern would not seem to apply to retirement savings, which are clearly more stable.
Capping the Insurance Fund and Expanding the Rebate Authority
The ABA has long advocated that the insurance fund should be capped and the rebate authority expanded. Not only are the BIF and SAIF currently fully capitalized, they are $3.2 billion over the 1.25 percent designated reserve ratio (DRR) set by Congress following the difficulties in the 1980s. Moreover, with interest income exceeding the FDIC’s operating expense by $1.5 billion a year, it is highly likely that the insurance funds will continue to grow, after deposit growth rates return to their norm, as we expect. The compounding effect will mean even greater rates of growth in the future. We believe the FDIC’s proposal on this point – which for the first time acknowledges the importance of rebates as a check on excessive growth of the fund – is a tremendous step forward. While in the past we have advocated direct rebates, a dividend approach, based on historic payments into the funds, accomplishes the same purpose and ABA supports that approach. The Federal Reserve and Treasury Department, in testimony before a House Financial Services Subcommittee last week, supported such an approach.
The funds held in excess of the DRR are not necessary to ensure the soundness of the deposit insurance system. As I mentioned above, the FDIC has the authority to adjust premium levels and has significant regulatory powers over depository institutions to ensure that the FDIC can meet any funding contingency. Importantly, the FDIC also has the authority to set aside a reserve to cover anticipated future losses. The power of this reserve was clearly demonstrated in the early 1990s when the FDIC reserved $16 billion for future losses, $13 billion of which was never needed. Because this reserve is subtracted out of the funds’ balances, the reserve ratios were dramatically understated at that time. This extra, and often overlooked, cushion provides an important tool for managing the funds resources. Perhaps most importantly, the banking industry is legally obligated to meet the financial needs of the insurance fund. Simply put, limiting the size of the fund and expanding the rebate or dividend authority will not affect the FDIC's ability to meet any future obligations to insured depositors.
The cost of FDIC holding excess reserves is very high. It represents a significant loss of lendable funds for banks in the communities they serve. I can tell you as a banker that I certainly can put rebates to good use in my community providing loans and services to my customers. This will have a far greater positive impact on economic conditions in Waverly, Iowa, than if that money sits in the government’s coffers in Washington.
As noted above, we believe that viewing the FDIC more as a mutual insurer will naturally lend itself to a rebate system, through the payment of dividends. While the details of a cap and dividend system need to be worked out, we believe the 1.40 percent cap proposed in S. 2293 (as introduced in the last Congress) and H.R. 4082 is a reasonable point at which to cap the funds. We thank Senator Santorum for his leadership on this issue.
There is a precedent for this type of system. The National Credit Union Administration has provided over $500 million over the last five years in dividends to credit unions. The dividend payment is designed to keep the National Credit Union Share Insurance Fund at 1.30 percent of insured deposits.
Premiums From Fast Growing Institutions
Bankers believe there is an inherent unfairness in the current system that allows fast growing institutions to pay no premiums, even though their growth materially dilutes the coverage reserve ratio of the insurance funds. For many bankers this has become a top priority in FDIC reform. The problem of fast growing institutions can be addressed through a combination of a dividend/rebate system under the mutual approach and granting the authority to the FDIC to charge premiums in cases where institutions are growing by a defined percentage over average growth at banks.
In a number of states municipal deposits are a significant source of funding, particularly for community banks. However, collateral requirements for municipal deposits often entail a costly administrative burden and have a very large opportunity cost by tying up funds in securities that could otherwise be used for additional lending in the community. This situation varies by state. The ABA will continue to work on suggestions for addressing collateral requirements.
A number of bankers advocate a hundred percent insurance on municipal deposits, or at least on local municipal deposits. They point to the huge administrative burden required to pledge bonds to collateralize these deposit, as well as the lost opportunities from holding excess bonds rather than making more loans. The ABA recognizes that 100 percent has raised economic and political concerns with some members of Congress due to "moral hazard" questions, and there is, frankly, no consensus within the industry on this issue at this point. There is, it is worth noting, precedent under current deposit insurance practices for a differentiation between municipal and other deposits. Therefore, we believe further work needs to be done on this issue. For example, consideration could be given to providing broader coverage or perhaps granting banks the option to purchase additional insurance for municipal deposits. Any such additional insurance should be limited to some definition of local deposits, and the cost of such additional insurance should fully cover any additional risk to the insurance fund.
Too Big To Fail
The ABA has long opposed the too-big-to-fail doctrine and worked with the Congress and regulators to include the limits on its use contained in FIRREA and FDICIA. Nevertheless, important aspects of this doctrine continue to exist. Deposit insurance reform provides an opportunity to revisit the too-big-to-fail doctrine, and hopefully, eliminate it fully.
Merger of the Funds
In the context of comprehensive reform, a merger of SAIF and BIF would be appropriate.
Smoothing Out Premiums
The FDIC is recommending that the "hard" 1.25 percent "Designated Reserve Ratio" (DRR) trigger be softened so that the industry would not be charged very high premiums all at once if the fund falls significantly below the 1.25 percent level. The ABA believes there is merit to smoothing premiums by eliminating the so-called "23-cent cliff" as long as it does not result in additional net premium payments over the long run. The current system is, in effect, a major tax increase in a recession. It is pro-cyclical and would undermine any economic recovery.
We are, however, troubled by the suggestion in the FDIC’s proposal that a band around the 1.25 DRR be established under which no rebate (if over-funded) or surcharge (if under-funded) would be provided. The FDIC would still charge regular premiums within this band. If the goal is always to return to the DRR level, then there should be no band around that level. Since the majority of the time there are few failures and losses, the fund will generally be above the upper level of the band. In effect, the broad approach would set a new de facto reserve level above 1.25 percent and would ignore the billions of dollars in lost lending opportunities of over-funding the FDIC.
Independent FDIC Board
Consideration should be given to changing the FDIC Board to make sure it is truly independent, as it is designed to be. The most direct way to do that would be to have three independent board members. Since the board was expanded to five members in FIRREA, more often than not, there have been vacancies on the board. The vacancies tend to be the "outside" seats because the seats held by the Comptroller of the Currency and the head of the Office of Thrift Supervision are always filled (either by the Comptroller or the head of OTS or acting directors of those organizations). Thus the Administration has generally had half of the Directors. Such an imbalance threatens the independence of the FDIC and could politicize decisions. Returning to a three-member independent board – which served the FDIC for well over 50 years – should be considered as part of a comprehensive approach to reform.
III. Changes should only be adopted if they do not create new costs to the industry
We must emphasize that we cannot support, and would oppose, any new approach that results in additional premium costs to those banks which are currently paying no premiums and which grow at normal rates. The example of a new premium structure used by the FDIC in its report would, for example, result in unacceptable premium increases for many banks. We see no justification for such increases when the insurance funds are above the required reserve ratio.
There are several arguments made for charging premiums to at least some banks that now pay no premiums. First, it is argued that to charge no premiums means these banks are not paying for their insurance. We couldn’t disagree more. Banks have paid for their insurance – they prepaid it. The billions of dollars in the BIF and SAIF are the result of premiums and interest on premiums. The fact that the FDIC is now self-funded is an extraordinary achievement.
Moreover, banks are obligated to maintain the fund at 1.25 percent of insured deposits. If the fund falls below this level, all institutions pay to recapitalize the fund. This assures adequate funding of the insurance fund. Even more important is that the banking industry has an unfailing obligation – set in law – to meet the financial needs of the insurance fund. This means that the entire capital of the industry – over $600 billion – stands behind the FDIC funds.
It is also worth noting that commercial banks and savings banks are paying nearly $800 million each year to cover FICO and interest payments; despite the fact that these institutions had nothing to do with the crisis that led to the issuance of the FICO bonds. Therefore, we have fully paid up our insurance and more. We must remind Congress that the current premium system was a carefully negotiated compromise with our industry in exchange for the picking up of the FICO interest payments. We see no justification for Congress’s unilaterally reworking that "agreement" with our industry when the funds remain above the 1.25 percent reserve ratio.
A second argument is that there must be gradations of risk in the upper category of banks. We are not at all persuaded that these gradations are significant or that the FDIC or anyone else has a system that can really make that differentiation with any degree of confidence. Furthermore, we believe there is a sort of "grade on the curve" implicit in this argument. The upper category is just that. Banks have worked hard to become stronger institutions, with strong capital; these banks are in the top category because they deserve to be there, as would be clearly shown by an historical perspective. We see no justification for changing the system now by arguing that there are too many banks in that category, after they have done what it takes to be strong, well managed and well capitalized.
Of utmost importance, bank premiums are funds that otherwise could be lent and invested in local communities. Charging new premiums takes that money out of communities, undermining economic growth.
Another potential cost that could severely impact bank lending would be a change in the assessment base related to Federal Home Loan Bank advances and other secured liabilities. This change was suggested in testimony last week by the Treasury Department. We believe that such actions are directly counter to the intent of Gramm-Leach-Bliley, which recognized the need for additional sources of funding for community banks, and the appropriate role that the Federal Home Loan Banks could play in filling that need. To alter the assessment base to now include Federal Home Loan Bank advances and other secured liabilities will hamper the ability of banks to fund themselves and their communities.
We would also note that changing the risk-based premium system may trigger other problems and costs. For example, the scoring system suggested by the FDIC could impose additional regulatory burdens and may conflict with examination ratings of the OCC, the Federal Reserve, and state banking departments. The Federal Reserve, in testimony last week before a House Financial Institutions Subcommittee, raised questions about how this new system might work. The Treasury Department noted in the same hearing that the approach was complicated and suggested it not be included in this legislation.
Mr. Chairman, we greatly appreciate the speed with which you have moved to hearings on this issue. We are prepared to work with you and the members of this subcommittee to find the best solution to these critical issues. We think this is an excellent time to begin that process – with the industry and the FDIC in excellent health. We sense there is a growing consensus on issues to be addressed and approaches to these issues. We look forward to working with you to see if we can develop and enact legislation to make the FDIC insurance system even stronger.
Capping the insurance fund and providing rebates will not limit the FDIC’s ability to meet any contingency. The FDIC has great flexibility to manage the funds to maximize effectiveness, and there are many existing laws that help protect the funds. For example, consider:
Reserves for Future Losses: FDIC has great flexibility to adjust reserves for future losses. This reserve fund is subtracted from the fund balance when calculating whether the fund is fully capitalized – i.e., if the fund balance is at least 1.25 percent of insured deposits. Obviously, the larger the reserve for future losses, the smaller the fund balance. Once the fund balance falls below 1.25 percent of insured deposits, premiums must be charged by the FDIC to fully capitalize the fund. Thus, if FDIC anticipates greater potential losses, it can merely set aside reserves, potentially creating a situation where banks would have to pay premiums to maintain the capitalization level of the fund. The FDIC has suggested that this "hard" target of 1.25 percent be "softened" allowing a slower recapitalization than possible under current law. It is important to note that even with such a change, the FDIC still would be able to set aside reserves for future losses, thereby affecting the level of the fund relative to the 1.25 percent level.
Authority to Raise the Designated Reserve Ratio (DRR): The FDIC has the authority to raise the DRR if it can document that it is justified for that year "by circumstances raising a significant risk of substantial future losses to the fund." By raising the DRR, the FDIC would likely be raising the assessments necessary to maintain that new higher level. Thus, if the FDIC foresees problems, it has this additional authority to easily deal with the situation.
Risk-Based Premiums: Risk-based premiums were authorized in 1991 by Congress and implemented in 1993. Several important points should be made: First, the risk-based system provides an automatic self-correcting mechanism. If industry conditions deteriorate and banks’ capital falls or supervisory concerns arise, a higher risk-premium is charged and more income is received in the fund. The FDIC has been critical of the fact that nearly 92 percent of the industry falls in the top-rated category and therefore pays no premiums. On the contrary, the incentives are such that nearly all banks want to be in this top category, and given the economic performance of the economy and the banking industry over the last decade, it’s no wonder that such a high percentage enjoys the benefits of such a rating.
Second, the FDIC has made additional changes to the risk-based system designed to identify patterns that signal future problems for individual banks. This should serve to improve the sensitivity of the risk-based system to changes, and build in the automatic adjustments sooner than would otherwise have been the case.
Mandatory Recapitalization: If the reserve ratio falls below the DRR, the banking industry must immediately rebuild the fund back to the DRR. If the rebuilding is expected to take longer than one year, a mandatory recapitalization plan at very high assessment rates (minimum 23 basis points of domestic deposits) must be established. Thus, if the industry continues to grow, the practical impact is that the fund balance will never fall below 1.25 percent of insured deposits for any length of time. In dollar terms, the fund would therefore always be over $35 billion. We agree with the FDIC that, in times of stress, the high premiums that would be required to maintain the DRR may be counterproductive. Moreover, a "hard" 1.25 percent level means that the benefits of such a large fund cushioning the shock of bank failure losses is lost. While maintaining a level of capitalization is important to preserving depositor confidence, proposals that would require a slower re-building would be beneficial to maintaining credit availability during difficult economic times. Again, it is worth noting that the reserves of future losses, mentioned above, provide a cushioning effect and should mitigate large upward swings in premiums.
Additional Authorities that Protect FDIC
Beyond the flexibility to adjust the deposit insurance funds to meet any contingency, there are other important laws and regulations that have fundamentally changed the operating environment for FDIC. Taken together, these provisions lower the probability of banks failing and reduce the cost to the FDIC from those that do fail.
Simply put, limits on the size of the insurance fund and expanding the rebate authority poses no concern to the FDIC funds – existing laws and regulations provide the needed flexibility to meet any financial obligation that may arise.
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