Uninsured money funds can also hedge such risks. ... A

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Deposit Insurance, Bank Regulation, and Financial
System Risks
by George Pennacchi Department of
Finance University of Illinois
FDIC - JFSR Conference on Emerging Risks in
Banking and Financial Services, September 22-23
2005
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Summary of the Paper

• The paper has three main parts
• Empirical evidence is presented that FDIC
  insurance is necessary for banks to hedge
  liquidity shocks. Uninsured money funds can also
  hedge such risks.
• Under-priced deposit insurance has led to
  excessive expansion of the safety net. Reforms
  that set insurance premiums to be actuarially
  fair would create incentives for banks to take
  excessive systematic risks.
• An alternative insurance plan may preserve the
  ability to hedge liquidity shocks but mitigate
  the incentive for systematic risks.

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Prior Research on Banks and Liquidity Risks

• Kashyap, Rajan, and Stein (2002) note that
  (demand) deposits and loan commitments are
  similar cash-management services.
• Providing them together conserves liquid assets
  needed to support both transactions. This
  synergy is greatest if deposit inflows tend to
  coincide with commitment draw-downs.
• Gatev and Strahan (2005) (GS) present empirical
  evidence that during 1988 - 2002, banks
  experienced deposit inflows and increased loans
  at times of liquidity shocks as proxied by the
  commercial paper - Treasury bill spread.
• Similarly, Gatev, Schuermann, and Strahan (2005)
  show that during the 1998 liquidity crisis, banks
  with the most loan commitments experienced the
  greatest deposit inflows.

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Hedging Liquidity and Deposit Insurance

• Is this beneficial correlation between loans and
  deposit flows an inherent feature of banks or is
  it due to deposit insurance?
• Similar to GS (2005), I estimate vector
  auto-regressions (VARs) to test whether an
  innovation to the commercial paper spread Granger
  - causes growth in various bank assets and
  deposits.
• In addition to replicating tests during the
  recent period of 1988 to 2004, I also estimate
  VARs using banking and market interest rate data
  from the NBER Macro-History Database for the
  pre-FDIC period of 1920 to 1933.

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Deposit Insurance is Critical for Bank Hedging

• This evidence is consistent with deposit
  insurance being vital to banks ability to hedge
  liquidity risks. Today, investors view (de
  facto) insured deposits as a safe haven during
  flights to quality.
• Prior to 1933, banks feared deposit withdrawals
  and held 99 of all commercial paper to meet
  deposit outflows.
• Unlike today, prior to the FDIC it was rare for
  banks to offer formal loan commitments.
• Is there another financial intermediary that can
  hedge liquidity shocks? I re-run VARs but use
  the growth rate of money market mutual fund
  (mmmf) shares as the dependent variable.

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MMMFs Also Experience Inflows Following Liquidity
Shocks

• Investors view mmmfs (especially institutional
  ones) as safe havens following market-wide
  liquidity shocks.
• Indeed, mmmfs may be a primary conduit that
  purchases banks large time deposits (CDs)
  following liquidity shocks.
• Investor confidence in mmmfs is consistent with
  Gorton and Pennacchi (1993) who find that mmmf
  shares do not decline following defaults on
  individual firms commercial paper.

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Governments Have Difficulty Pricing Insurance

• Stiglitz (1993) argues that a government deposit
  insurer faces political constraints that limit
  its ability to charge market-based deposit
  insurance premiums
• The difficulties government has in assessing
  risk, and that citizens face in evaluating the
  governments performance on this score, provide
  an opportunity for granting huge hidden
  subsidies.
• Since 1996, over 90 of all banks have paid
  nothing for deposit insurance, undoubtedly
  representing a huge subsidy.

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Free Lunches

• Recent examples of excessive expansion of the
  safety net
• Promontory Interfinancials CDARS network allows
  banks to swap lt 100,000 chunks of large CDs to
  skirt the 100,000 FDIC limit, allowing insurance
  for a 20 million deposit.
• The 1999 GLB Act allowed brokerage firms to
  affiliate with insured banks and convert
  customers sweep accounts from mmmfs into
  FDIC-insured deposits.
• Crane and Krasner (2004) estimate that 350
  billion is in FDIC-insured deposits that would
  have been in retail mmmfs. A shift of 50 to 100
  billion per year is forecast for 2005 and 2006.
• From 2000-2005, MMDAs grew at a 16.4 annual
  rate while shares of retail mmmfs declined at a
  3.0 annual rate.

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Actuarially Fair Premiums to the Rescue?

• Most FDIC (2000, 2001) proposals to reform
  insurance pricing and Basel II capital
  requirements fail to distinguish between
  systematic versus idiosyncratic risks.
• But deposit insurance is inherently systematic
  bank failures tend to be greater during business
  cycle downturns.
• The model in Kupiec (2004) shows that Basel II
  provides incentives for banks to take excessive
  systematic risks.
• I use a similar model to show that if insurance
  premiums equal expected losses (actuarially
  fair), then banks continue to have incentives to
  take excessive systematic risks.

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Subsidizing Financial Instability

• Operationally, a bank can identify procyclical
  investments by choosing those loans, loan
  commitments, or selling credit protection swaps
  that have the highest spreads or fees for a given
  probability of loss.
• In equilibrium, this subsidization of systematic
  risk can magnify the amplitude of business
  cycles. FDIC losses will occur when federal
  budget deficits are highest.

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An Alternative Insurance Plan

• Motivated by the empirical evidence that money
  funds experience inflows following liquidity
  shocks, I model a money fund whose assets are
  uninsured bank CDs and/or finance company paper.
• The model shows that if a government provides
  actuarially fair insurance for this money fund
  rather than bank deposits, the incentive for
  systematic risk is mitigated.
• Intuition Total and systematic risk is less by
  insuring a portfolio of CDs (money fund) versus
  insuring a single CD (bank).

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Affiliation Can Preserve Information Capital

• An insured money fund could operate as a bank
  affiliate that issues insured deposits
  collateralized by money market debt.
• Checking account information that reduces a
  lenders monitoring costs can be preserved.
  Mester, Nakamura, and Renault (2003).
• Bank credit information may be used by the fund
  to select CDs and commercial paper. Massa and
  Rehman (2005).
• Government regulation of insured money funds is
  far less costly and complex. Too-big-to-fail
  bailouts would be less likely.
• Following liquidity shocks, insured money funds
  would allocate inflows to credit-worthy banks and
  finance companies who, in turn, would extend
  credit to firms (under loan commitments).

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Conclusions

• Risks that are large and systematic are difficult
  for a private institution to insure. Pooling
  them does not eliminate systematic risk that can
  bankrupt a private insurer.
• Thus, a government may insure systematic risks,
  but political constraints limit its ability to
  charge systematic risk premia.
• As a result, the subsidization of systematic risk
  creates moral hazard that can worsen business
  cycles.
• The proposed money fund-based insurance system is
  not radical. Prior to FDIC insurance, banks held
  the vast majority of money market securities,
  similar to the money funds of today.