Financial Update (April-June 1997)

Capital Notes Plan Would Help
Monitor Deposit Insurance Fund

A re existing regulatory policies adequately limiting taxpayers' exposure to deposit insurance losses? If Congress passes financial modernization, how could it obtain an independent analysis of whether the regulators were adequately limiting taxpayer exposure to losses at banks and their affiliates?

Larry D. Wall, a research officer in the financial section of the Atlanta Fed's research department, proposed a method to answer these questions in an article published recently in the Atlanta Fed's Economic Review.

The proposal calls for the Federal Deposit Insurance Corporation (FDIC) to issue securities for which the promise of payment is contingent on the state of the insurance fund. For example, if the fund required taxpayer contributions to satisfy its deposit insurance obligations, then the securities would receive no payment. The notes would be called capital notes because their promised payments would depend on the level (or capital) in the deposit insurance fund. Although capital noteholders would necessarily be subject to risk, the primary purpose of the notes is not to substitute for bank-supplied funds in absorbing the risk of loss but to produce information about the risks facing the fund.

Wall points to two problems with existing bank supervision that could be mitigated by capital notes. First, many of the activities that banks currently engage in or want to enter are difficult to monitor and regulate because of their complexity. Banks would have an incentive to downplay any risks posed by these activities to the supervisors and Congress. Capital notes could provide an independent signal to regulators and Congress about the magnitude of the risks facing the deposit insurer. This signal would provide both regulators and Congress greater confidence as they proceed with deregulation.

A second problem with current supervision is that regulators face conflicting incentives that sometimes result in their giving insufficient weight to protecting the deposit insurance fund. Wall's proposal would reduce these problems in a variety of ways. First, it would create more information about the quality of bank regulation that would encourage regulators to focus more on protecting the insurance fund in order to protect their reputations. Second, the proposal would recommend that the directors of the FDIC be required to invest in the capital notes. Third, the proposal provides information that would facilitate congressional oversight when the fund is under greater stress.

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