No Room for Weak Links in the Chain of Deposit Insurance Reform

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Unrecognized and deferred losses at insured deposit institutions currently impair the capacity of the nation's principal deposit insurers (the FDIC and FSLIC) both to discipline failing institutions and to discipline or take over insolvent ones. These agencies' accrued but unreported losses far exceed their explicit financial resources. Moreover, their backlog of unresolved problem cases far exceeds the workload that their existing staffs can handle. What holds the deposit-institution system together is financial-market participants' so-far-unshakable faith that politicians and bureaucrats cannot afford to let the FDIC and FSLIC renege on the obligations that they and their predecessors have permitted these agencies to assume. Underlying this belief is a conjectural economic assessment of the strength and constancy of incentives that direct elected politicians to bail out politically sensitive enterprises. This paper addresses three tasks: (1) to clarify the defects in the information, monitoring, regulatory-response, and incentive sub-systems of federal deposit insurance that, by subsidizing institutional risk-taking, led so many deposit institutions and their insurers into economic insolvency; (2) to identify a generic mix of reforms that could in principle put the system right again; and (3) to explain how far proposals for reform that hold a place on the active legislative and regulatory agenda fall short of this ideal.

Published: Journal of Financial Services Research, Vol. 1, No. 1, September 1987, pp. 77-111.

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