VIEWPOINTS : Use Private Insurance to Protect Deposits
As a financial crisis spreads from U.S. savings and loans to commercial banks, extraordinary measures must be taken to stop the hemorrhage of funds from the Federal Deposit Insurance Corp.’s insurance fund. Nevertheless, federal regulators continue to look at only one solution to shore up the fund: raise the premiums paid by institutions.
Ironically, such a solution could make the problem worse. A 62% increase in bank premiums--announced by the FDIC for next year--could further jeopardize the survival of many institutions, adding fuel to a cycle of commercial bank failures.
What is required is a fundamentally new approach that focuses attention on the asset side of a bank’s balance sheet by using private insurance on individual loans in bank portfolios. Such a plan would shift the risk of insuring bank deposits--at least in part--from taxpayers to the insurance industry.
Unlike the government, insurance companies are structured to assess risk and provide insurance services at a profit. In the process, the costs of insuring individual loans ultimately would be passed on to borrowers, where the responsibility most properly belongs.
Under current government policy, banks are required to insure deposits by paying premiums to the FDIC’s insurance fund. Those premiums are calculated on a flat rate determined solely by the size of the institution. The fund has deteriorated rapidly, just at a time when its exposure to significant new losses is higher than ever. At the end of last year, the ratio of the insurance fund’s reserves to deposits had fallen to the lowest point in its history--0.7%.
The prospect for the fund achieving the minimum reserve ratio of 1.25% by 1995 under new federal rules “is not good,” says Charles A. Bowsher, U.S. comptroller general.
Regulators have considered instituting a risk-based premium rate for commercial banks, depending on the type of loans they make. Insurance premiums under this plan would be calculated by a variety of factors, including the type and risk of loans made by the institutions. Banks with portfolios in predominantly low-risk categories would pay lower premiums than institutions with higher-risk portfolios.
A shift to a risk-based system makes sense. It is more consistent with the ways insurance premiums are typically priced in policies ranging from autos to health. But still, taxpayers ultimately would carry the burden of replenishing the fund to cover bank failures.
Private insurance of individual loans represents an important departure from existing regulatory policy. Under this practice, bankers would solicit insurance policies similar to private mortgage insurance, or PMI, for individual loans. Insurance companies would evaluate the risk on a loan-by-loan basis and determine when they would provide coverage. Banks, in turn, would pay reduced premiums to the FDIC, depending on how much of their loan portfolios are reinsured by private carriers.
This approach would “lay off” a portion of the risk on private insurance companies and yield a number of benefits. The first source of repayment of a loan would be the borrowers, while the second would be the insurance company. That would help defray the number of claims against the FDIC deposit fund. Private insurers, in turn, would transfer the cost of insurance to borrowers.
Is this approach politically and economically viable? A number of objections could be raised.
First, it could be argued that the plan would discriminate against some borrowers. Only borrowers with high qualifications capable of meeting insurance criteria would be able to obtain financing. This differs significantly from the current system, which is indiscriminate in relation to borrowers and operates on a “blind pool” insurance basis.
Second, bankers may object that the plan could give insurance companies too much influence in bank loan underwriting criteria. This plan, however, would force banks to re-examine their loan underwriting policies to meet the requirements of insurance companies--ultimately benefiting institutions and reducing their losses. Standard & Poor’s underwriting criteria, now used in commercial real estate lending, might be modified for use by banks.
Insurance companies would need to establish some type of loss experience model in developing a premium schedule that was realistic and viable. This would involve research and maintenance of a loan-loss database and model. Both would be easy to develop. Federal and state agencies maintain comprehensive statistics on actual losses incurred by every financial institution in the country. This data would provide a solid foundation for establishing criteria to assess loan risk.
In the end, insurance companies are better positioned to take on the risk of insuring loans. For these companies, insurance of commercial banks would represent only one line of business, with risk dispersed nationally. An insurance company that insures against the collectibility of a loan would be able to quantify risk on a loan-by-loan basis. This makes more sense than quantifying risk based on the overall operations of a financial institution, which is the current practice.
In the event that private insurers were unwilling or unable to provide loan coverage, the federal government could offer coverage through an insurance company it established to provide these policies. This too would represent a better approach to managing risk in loan portfolios than simply changing the FDIC insurance premium schedule to rebuild the fund, or asking Congress to approve an emergency appropriation.
By private insuring of individual loans, the basis for managing risk would be more fairly assessed, in the process protecting the FDIC’s insurance fund from further erosions and banks against greater threat of failures.
