Assessments

[[Page 42680]]

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 327

RIN 3064-AB58

Assessments

AGENCY: Federal Deposit Insurance Corporation.

ACTION: Final rule.

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SUMMARY: The Board of Directors (Board) of the Federal Deposit

Insurance Corporation (FDIC) is amending the FDIC's regulation on

assessments to establish a new assessment rate schedule of 4 to 31

basis points for institutions whose deposits are subject to assessment

by the Bank Insurance Fund (BIF). In addition, the Board is amending

the assessment schedule to widen the existing assessment rate spread

from 8 basis points to 27 basis points. The Board is further amending

the assessments regulation to establish a procedure for adjusting the

rate schedule semiannually as necessary to maintain the designated

reserve ratio (DRR) at 1.25 percent.

The Board is adopting the new assessment schedule to satisfy the

requirements of section 7(b) of the Federal Deposit Insurance Act that,

once the reserve ratio of the BIF reaches the DRR of 1.25 percent of

total estimated insured deposits, rates be set to maintain the DRR. The

new schedule will apply to the semiannual period in which the DRR has

been achieved (which is expected to occur in the second quarter of

1995) and to semiannual periods thereafter, subject to modification

semiannually by the FDIC. Specifically, the new assessment schedule,

which will reduce BIF assessment rates for all but the riskiest

institutions, will become effective on the first day of the month after

the month in which the DRR is achieved. Assessments collected at the

previous assessment schedule that exceed the amount due under the new

schedule will be refunded, with interest, from the effective date of

the new schedule.

EFFECTIVE DATE: September 15, 1995.

FOR FURTHER INFORMATION CONTACT: Frederick S. Carns, Chief, Financial

Markets Section, Division of Research and Statistics, (202) 898-3930;

Christine Blair, Financial Economist, Division of Research and

Statistics, (202) 898-3936; Connie Brindle, Chief, Assessment

Operations Section, Division of Finance, (703) 516-5553; Claude A.

Rollin, Senior Counsel, Legal Division (202) 898-3985; or Martha

Coulter, Counsel, Legal Division (202) 898-7348, Federal Deposit

Insurance Corporation, Washington, DC 20429.

SUPPLEMENTARY INFORMATION:

I. Background

On February 16, 1995, the Board published for public comment a

proposal to lower the assessment rate schedule for BIF members to 4 to

31 basis points from the current schedule of 23 to 31 basis points. The

Board further proposed to amend the assessment rate matrix to widen the

existing rate spread from 8 basis points to 27 basis points. 60 FR 9270

(Feb. 16, 1995). The Board is now adopting the proposed amendments with

minor modifications.

Under the assessment schedule currently in effect, BIF members have

been assessed rates for FDIC insurance ranging from 23 basis points for

institutions with the best assessment risk classification to 31 basis

points for the riskiest institutions. This assessment schedule was

based on the requirements of section 7(b)(2)(E) of the Federal Deposit

Insurance Act (FDI Act), 12 U.S.C. 1817(b)(2)(E). That provision was

enacted as part of section 302 of the Federal Deposit Insurance

Corporation Improvement Act of 1991 (FDICIA) (Pub. L. 102-242, 105

Stat. 2236, 2345) which completely revised the assessment provisions of

the FDI Act by requiring the FDIC to: (1) Establish a system of risk-

based assessments; (2) establish assessment rates sufficient to provide

revenue at least equivalent to that generated by an annual 23 basis

point rate until the BIF reserve ratio 1 achieves the DRR of 1.25

percent 2 of total estimated insured deposits; (3) when the

reserve ratio remains below the DRR of 1.25 percent, set rates to

achieve that ratio within one year or establish a recapitalization

schedule to do so within 15 years; and (4) once the DRR is achieved,

set rates to maintain the reserve ratio at the DRR.

\1\ The reserve ratio is the dollar amount of the BIF fund

balance divided by the estimated insured deposits of BIF members.

\2\ The DRR of 1.25 percent is equivalent to $1.25 for each $100

of estimated insured deposits.

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Due to the health of the banking industry, current projections

indicate that the BIF may have recapitalized sometime during the second

quarter of 1995, although recapitalization has not yet been verified.

The actual month of recapitalization cannot be confirmed until data

from the June 30, 1995, Reports of Condition and Income (call reports)

is processed, which the FDIC expects to occur early in September.

Accordingly, to implement the statutory provisions which will apply

once the DRR is reached, the Board is adopting an assessment rate

schedule for BIF members of 4 to 31 basis points that will become

effective the first day of the month after the month in which the DRR

is achieved. Assessments collected at the previous rate schedule that

exceed the amounts due under the new schedule after the DRR has been

achieved will be refunded in one or more payments, with interest, from

the effective date of the new schedule (or, in the case of June 30

overpayments, from June 30 or, if later, the actual payment date). As

proposed, the Board is further adopting a process to adjust rates

semiannually without a new notice-and-comment rulemaking proceeding,

using an adjustment factor of 5 basis points.

At the request of Board Member Jonathan Fiechter and interested

outside parties, the Board held a hearing at FDIC headquarters in

Washington, D.C. on March 17, 1995, to provide the opportunity for

interested parties to express orally their views on the proposals to

decrease assessment rates for members of the BIF while retaining the

existing 23 to 31 basis point assessment schedule for members of the

Savings Association Insurance Fund (SAIF), on the competitive impact of

the disparity between BIF and SAIF rates, and on possible solutions for

recapitalizing the SAIF and paying the interest on Financing

Corporation bonds. Every person or organization that requested an

opportunity to testify was accommodated.

A total of twenty witnesses were heard by the full FDIC Board

during the day-long hearing. They included the American Bankers

Association (ABA), the Independent Bankers Association of America

(IBAA), America's Community Bankers, the Savings Association Insurance

Fund Industry Advisory Committee, the National Association of Home

Builders, representatives of several bank and thrift state

associations, individual bank and thrift executives, a private sector

attorney, and an independent consultant. The written testimony of each

witness as well as the hearing record are included in the FDIC's public

comment file on the two proposals.

In total, the FDIC received over 3,200 comments on the BIF proposal

(together with the comments received on the Board's proposal to retain

the existing assessment rate schedule for members of the Savings

Association Insurance Fund), including the testimony from the public

hearing. After taking account of duplicates, 2,891 comments were

tabulated representing 2,310 individual BIF member respondents, 454

[[Page 42681]]

individual SAIF member respondents, 61 trade associations and 66 other

individuals/organizations.

Following is a discussion of: (1) The statutory framework for

setting assessment rates, (2) the new assessment rate spread, (3) the

new assessment rate schedule, (4) the method for applying the schedule

in the semiannual period during which the DRR is achieved, and (5) the

process for limited adjustment of the new schedule in future semiannual

periods. A summary of the comments received is included with the

specific issue(s) addressed by the parties submitting comments.

II. Statutory Framework for Setting Assessment Rates

A. Introduction

Section 7(b) of the FDI Act governs the Board's authority for

setting assessment rates for members of the BIF. 12 U.S.C. 1817(b).

Section 7(b)(1) (A) and (C) require that the FDIC maintain a risk-based

assessment system, setting assessments based on (1) the probable risk

to the fund posed by each insured depository institution taking into

account different categories and concentrations of assets and

liabilities and any other relevant factors; (2) the likely amount of

any such loss; and (3) the revenue needs of the fund. Section

7(b)(2)(A) of the FDI Act requires the Board to set semiannual

assessments to maintain the BIF reserve ratio at the DRR once the BIF

is recapitalized,3 taking into consideration the fund's: (1)

Expected operating expenses; (2) case resolution expenditures and

income; (3) the effect of assessments on members' earnings and capital;

and (4) any other factors that the Board may deem appropriate. Section

7(b)(2)(A)(iii) further directs the Board to impose on each institution

a minimum assessment of not less than $1,000 semiannually. When the

reserve ratio remains below the DRR, the statute explicitly directs the

Board to set rates that will at a minimum generate revenue equivalent

to the amount generated by an average assessment rate of 23 basis

points. FDI Act, section 7(b)(2)(E).

\3\ The DRR of the BIF currently is 1.25 percent of estimated

insured deposits. FDI Act, section 7(b)(2)(A)(iv). The Board may

increase the DRR to such higher percentage as the Board determines

to be justified for a particular year by circumstances raising a

significant risk of substantial future losses to the fund. However,

the Board is not authorized to decrease the DRR below 1.25 percent.

Id.

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For the first time since the current provisions of section 7(b)

were enacted in 1991, the determination that the BIF has achieved the

DRR is imminent and, therefore, the minimum 23 basis point average

assessment requirement will no longer apply. Accordingly, the Board

must now establish an assessment schedule that satisfies the directive

of section 7(b)(1) to establish a risk-based assessment system, based

on the statutory factors which must be considered in that

determination; and the directive of section 7(b)(2) to maintain the BIF

reserve ratio at 1.25 percent, considering the statutory factors which

must inform that decision. As a practical matter, there is significant

overlap between the factors to be considered under section 7(b)(1) and

those to be considered under section 7(b)(2). For example, in

determining risk-based assessments, the Board must consider the

probability and likely amount of losses to the fund. When setting

assessments to maintain the reserve ratio at the DRR, the Board must

consider the same underlying data but denominated as ``case resolution

expenditures''. Thus, these determinations are interdependent and any

decision concerning an appropriate assessment schedule will consider

and balance all of the statutory factors that underlie these two

directives.

In the current favorable economic environment even with assessment

rates as low as prudently possible consistent with the Board's

fiduciary responsibilities to the insurance fund, the FDIC recognizes

that the reserve ratio may grow beyond 1.25 percent as a result of the

impact on the fund balance of revenues generated from risk-based

assessments, the $1,000 semiannual minimum assessment, and investment

income. Under these circumstances, any new assessment schedule adopted

by the Board must be the result of balancing the directive to maintain

a risk-based assessment system (and the statutory factors attendant

thereto) and the directive to set rates to maintain the DRR (and the

statutory factors attendant thereto). As discussed more fully below,

the statute and the legislative history provide little guidance as to

how to weigh the wide range of statutory factors that go into this

decision. The following sections address the Board's interpretation of

the interplay of the directives of section 7(b) and include a

discussion of comments received on the related issues in the proposal.

B. Maintain ``At'' the DRR

The Board is adopting the proposed interpretation of the statutory

requirement to maintain the reserve ratio at the DRR in which the Board

views the DRR as a target. Pursuant to section 7(b)(2)(A)(i) of the FDI

Act, the Board must set semiannual assessments to maintain the reserve

ratio of the BIF at the DRR taking into consideration the following

factors: (1) Expected operating expenses; (2) case resolution

expenditures and income; (3) the effect of assessments on members'

earnings and capital; and (4) any other factors the Board may deem

appropriate.4 Section 7(b)(2)(A)(iii) limits the Board's

discretion to set assessment rates by imposing a minimum semiannual

assessment of $1,000 per BIF member.5

\4\ The directive to ``set rates to maintain the reserve ratio

at the designated reserve ratio'' was enacted as part of the

amendments to section 7 made by the FDIC Assessment Rate Act of 1990

(Assessment Rate Act). Pub. L. 101-508, 104 Stat. 1388, 1388-14. The

Assessment Rate Act is Subtitle A of Title II of the Omnibus Budget

Reconciliation Act of 1990. See, discussion of legislative history

in the proposed regulation. 60 FR 9270 at 9272 (Feb. 16, 1995).

\5\ As enacted in FDICIA, section 7(b)(2)(A)(iii) of the FDI Act

provides that the semiannual assessment for each member of a deposit

insurance fund shall be not less than $1,000. Accordingly, BIF

members must pay the greater of their risk-based rate or $2000 each

year.

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As stated in the proposal, the Board views the DRR as a target

around which the actual reserve ratio would fluctuate, rather than as a

rigid ceiling above which the reserve ratio could not rise even

slightly.6 The Board based this interpretation on (1) the

impossibility of controlling the economic factors which affect the size

of the BIF; (2) the legislative history of section 7(b); and (3) the

other statutory directives of section 7(b) that the FDIC establish a

system of risk-based assessments and impose a minimum semiannual

assessment of $1,000 (either of which may cause the reserve ratio to

exceed 1.25 percent in the current economic circumstances). The Board

further stated that in the event the reserve ratio exceeds the DRR due

to economic factors beyond its control (such as the level of investment

income) or as a result of effectuating other statutory directives (such

as the requirement to have a risk-based assessment system), the Board

considers that it will have complied with the statute because the Board

will have set rates to maintain the reserve ratio at 1.25 percent in

[[Page 42682]]

accordance with statutory requirements for a risk-based assessment

system and a minimum semiannual assessment. The Board is adopting this

interpretation with added discussion to clarify the need to balance the

directives of section 7(b) and the statutory factors which must be

considered in that balancing decision.

\6\ Treating the DRR as a target would necessarily include the

concept of fluctuations above and below the target. If the reserve

ratio falls below 1.25% in a semiannual period, the Board could

adjust the assessment schedule in the next semiannual period to

restore the ratio. Section 7(b)(3)(A) of the FDI Act contemplates

precisely that. That section provides that, after the DRR is

achieved, if the reserve ratio falls below the DRR, the Board is

required to set semiannual assessments sufficient to increase the

reserve ratio to the DRR within one year or in accordance with a

recapitalization schedule promulgated to restore the reserve ratio

to the DRR within 15 years. Conversely, when the reserve ratio rises

above the DRR for any period, the Board could adjust the assessment

schedule downward to reflect the increase.

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1. Comments

The appropriate interpretation of the directive to ``maintain the

reserve ratio at the designated reserve ratio'' was one of the issues

that elicited the greatest response from commenters. Of the 864

respondents that addressed this issue, 851 (813 BIF members, 30 trade

associations, 4 SAIF members and 4 other individuals or organizations)

believed that the DRR of 1.25 percent should be interpreted as a

precise number or a ceiling and that all assessment revenue (and in

some cases investment income) in excess of 1.25 percent should be

returned to BIF members. Thirteen respondents (8 BIF members, 2 trade

associations, 2 SAIF members and 1 other individual) agreed with the

Board that the DRR is necessarily a target about which the reserve

ratio will fluctuate. As noted above, the concept of the DRR as a

precise number above which the BIF may not rise necessarily requires a

mechanism to return excess assessments. See Section II.D below for a

discussion of comments addressing the FDIC's authority to provide

rebates. By contrast, the Center for Study of Responsive Law/Essential

Information interpreted the statutory DRR as a floor and urged the FDIC

to establish a higher range for the DRR with a target average of 1.63

percent using 1.25 percent as the floor and 2.0 percent as the ceiling.

Numerous commenters stated that the Board may not intentionally set

assessments at a level which, based on its own projections, will

increase the reserve ratio above the DRR. Accordingly, many have

asserted that by setting the proposed assessment schedule at 4 to 31

basis points, the Board will have, in effect, knowingly set the rates

to increase the DRR above 1.25 percent without making the required

statutory finding to increase the DRR. This assertion was based on a

misreading of a chart publicly distributed at the Board meeting on the

proposals indicating that under the proposed rate schedule, the reserve

ratio would rise to 1.30 percent in 1995 and 1.33 percent in 1996 and

remain above the DRR until the year 2001. The projections in the chart

did not reflect the possibility of semiannual changes that the Board

might make to the assessment schedule.

For example, the primary argument of the ABA is that the Board

cannot intentionally set assessments to generate assessment income

which its own predictions show will increase the reserve ratio above

the DRR. According to the ABA, to do so would render meaningless the

requirement that the Board must make a determination that circumstances

raising a significant risk of substantial future losses to the fund

justify an increase in the DRR. Similarly, the IBAA stated that in

light of its own projections, FDIC appears to be managing the fund at a

level higher than 1.25 percent.

2. The Board's Rationale for Interpreting the DRR as a Target

As described more fully below, the Board continues to believe that

viewing the DRR as a target to be maintained over time is the correct

position because: (1) It reflects the inconstancy of economic factors

which make it impossible for the FDIC to maintain the reserve ratio

precisely at 1.25 percent; (2) it better comports with Congress' view

of the DRR as a target as indicated by the legislative history and the

practical impact of Congress' elimination of the FDIC's rebate

authority in section 7(d); and (3) it gives effect to other provisions

of section 7(b), most importantly, the requirement for a risk-based

assessment system. A discussion of each of these elements of the

Board's rationale follows.

(a) Management of Reserve is Imprecise. The first element upon

which the Board based its interpretation of the ``maintain at''

requirement is the FDIC's inability to control economic factors which

affect the size of the reserve ratio, thereby making it impossible to

manage the BIF precisely at 1.25 percent. Changes in the reserve ratio

are a function of the amount of insured deposits, investment earnings,

assessment revenue (which, in turn, is a function of the risk profile

of the industry and revenue received from the statutory minimum

assessment), and revenue from corporate-owned and other assets, none of

which is in the complete control of the FDIC. In addition, operating

expenses and insurance losses, including the provision for future

losses, will vary. Even with regard to the elapsed time between the

setting of rates for an upcoming semiannual assessment period and the

end of that period, there is a potential for variations in all of these

factors, thus making it impossible to manage the reserve ratio

precisely at the DRR.

Moreover, Congress must have understood that the reserve ratio

cannot be maintained precisely at 1.25 percent because such an

interpretation would require that amounts in excess of 1.25 percent be

returned to the industry. In the current economic environment, the fund

will likely grow beyond the DRR as a result of investment income and

revenue generated by the risk-based assessment system. Thus, an

interpretation which requires the FDIC to maintain the reserve ratio

precisely at 1.25 percent would necessarily require a mechanism for

providing assessment credits (known as rebates) to BIF members for

amounts in excess of 1.25 percent. However, as discussed more fully in

Section II.D below, in FDICIA Congress deleted the FDIC's authority in

section 7(d), 12 U.S.C. 1817(d), to provide rebates. In addition,

Congress can be presumed to have been aware that at no time in its 62-

year history has the FDIC rebated investment income to the industry,

including the period from 1989-1990 which was the only time that the

FDIC had the authority to rebate investment income. Indeed, even if the

FDIC's last-existing rebate authority had not been removed on January

1, 1994, investment income could not be rebated and could cause the

reserve ratio to rise even with minimal assessments.

(b) Legislative History. The second element upon which the Board

based its interpretation of the ``maintain at'' requirement is the

legislative history of section 7(b). Section 208 of the Financial

Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA)

amended section 7(b) of the FDI Act to establish a DRR and set the

level at 1.25 percent. Pub. L. 101-73, 103 Stat. 183, 206. Prior to

FIRREA, beginning in 1980, the FDI Act required or authorized the Board

to adjust the amount of assessment income transferred to the insurance

fund, and thereby to increase or decrease the rebate amount, based on

the actual reserve ratio of the fund within a range from 1.10 percent

to 1.40 percent, with 1.25 percent as the target.\7\

\7\ Consumer Checking Account Equity Act of 1980, enacted as

Title III of the Depository Institutions Deregulation and Monetary

Control Act of 1980, Pub. L. 96-221, 94 Stat. 132, 148.

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FIRREA also prescribed minimum annual assessment rates which could

be increased from the scheduled levels, ``if necessary to restore the

fund's ratio of reserves to insured deposits to its target level within

a reasonable period of time.'' [Emphasis added.] H.R. Conf. Rep. No.

222, 101st Cong., 1st Sess. 396 (1989).

The legislative history of Congressional hearings in the year prior

[[Page 42683]]

to enacting FIRREA is replete with references to the 1.25 percent

reserve ratio as a target. Thus, when the DRR was established, Congress

viewed the DRR as a target level.

The next year, in 1990, the Senate Banking Committee clearly

considered the DRR a target as is demonstrated in the section-by-

section analysis of S. 3045, the language of which was almost identical

to the Administration bill, S.3093, which was ultimately enacted as the

Assessment Rate Act of 1990. That analysis repeatedly referred to 1.25

percent as the ``target level''. Finally, FDICIA section 104,

Recapitalizing the Bank Insurance Fund, amended the assessment rate

provisions of section 7(b)(1)(C) (in effect December 19, 1991, through

December 31, 1993) as follows:

If the reserve ratio of the Bank Insurance Fund equals or

exceeds the fund's designated reserve ratio under subparagraph (B),

the Board of Directors shall set semiannual assessment rates for

members of that fund as appropriate to maintain the reserve ratio at

the designated reserve ratio. [Emphasis added.]

This language is particularly compelling because its genesis was in

S. 543, the same bill which removed the FDIC's rebate authority and

which was the source of FDICIA's amendments to section 7 of the FDI

Act. Thus Congress appears to have recognized that the reserve ratio

would not remain precisely at a target DRR and could exceed that level.

(c) Other Statutory Directives of Section 7(b). The third element

upon which the Board has based its interpretation of the ``maintain

at'' directive consists of the other mandates of section 7(b): to have

an effective risk-based assessment system and to impose a minimum

semiannual assessment of $1,000.

The Board believes that to be effective, the risk-based assessment

system must incorporate a range of rates that provides an incentive for

institutions to control risk-taking behavior while at the same time

covering the long-term costs of the obligations undertaken by the

deposit insurer.

Specifically, section 7(b)(1)(C) of the FDI Act required the FDIC

to establish a risk-based assessment system for calculating an

institution's assessments based on:

(i) The probability that the deposit insurance fund will incur a

loss with respect to the institution, taking into consideration the

risks attributable to--

(I) Different categories and concentrations of assets;

(II) Different categories and concentrations of liabilities, both

insured and uninsured, contingent and noncontingent;

(III) Any other factors the Corporation determines are relevant to

assessing such probability;

(ii) The likely amount of any such loss; and

(iii) The revenue needs of the deposit insurance fund.

Within the scope of these broad factors, the FDIC was granted

complete discretion to design a risk-based assessment system.\8\ See,

i.e., S. Rep. No. 167, 102d Cong., 1st Sess., 57 (1991).

\8\ One statutory restraint, however, is that the system must be

designed so that as long as the BIF reserve ratio remains below the

DRR, the total amount raised by semiannual assessments on members

cannot be less than the total amount resulting from a flat rate of

23 basis points. FDI Act, section 7(b)(2)(E). Although this

provision will cease to be effective when the BIF reaches the DRR,

it may again become operative if the reserve ratio remains below the

DRR at some future time. The Board interprets the minimum assessment

provision of section 7(b)(2)(E), which requires weighted average

assessments of 23 basis points, as applying only when the reserve

ratio remains below the DRR for at least a year.

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It is clear from the legislative history of FDICIA that Congress

viewed the flat-rate assessment system as providing perverse incentives

for institutions to undertake risky activities funded by insured

deposits because they were not being charged for that risk, in effect

penalizing well-managed institutions. S. Rep. No. 167, 102d Cong., 1st

Sess. 56 (1991). By contrast, risk-based assessments were intended to

reduce risk to the BIF by encouraging banks to confine themselves to

safe and sound activities and decreasing the subsidization of risky

banks by more prudent institutions. Id.

The ABA has asserted that a risk-based assessment system is

unnecessary when the BIF does not need assessment income and that the

requirement for such a system applies only to determining the spread

between the highest and lowest rates in the assessment schedule. Once

the spread is determined, then the appropriate schedule is based solely

on the revenue needs of the fund. The Board disagrees with this

interpretation because it gives effect only to the statutory

requirement that the revenue needs of the fund be taken into account

when establishing or revising risk-based assessment rates. Such an

interpretation would ignore the compelling legislative history

indicating Congress' firm determination that banks be assessed on the

basis of the risk that their activities pose to the BIF and that they

be subject to appropriate economic disincentives to risky behavior.

In summary, the Board believes that to be effective, the risk-based

assessment system must incorporate a range of rates that provides an

incentive for banks to control risk-taking while at the same time

taking into account the long-term costs of the risks borne by the

deposit insurer. The Board is well aware that the assessment income

generated by an effective risk-based assessment system and the minimum

semiannual assessment may, in the current economic situation, cause the

reserve ratio to rise above the target DRR of 1.25 percent. Even so, as

discussed more fully below, this does not eliminate the necessity for

the Board to balance the directives of section 7(b) to have an

effective risk-based assessment system while at the same time setting

rates that will maintain the reserve ratio at the target DRR by giving

full consideration to the enumerated statutory factors that are the

determinants of the assessment schedule.

C. Balancing

As discussed below, the main purpose of S. 543 (the bill that

contained the language of current section 7(b)) was to assure that the

BIF would be recapitalized so that taxpayer funds would not be at risk.

Accordingly, while the statute is specific with respect to the actions

the Board must take to set rates when the reserve ratio is below the

DRR, neither the statute nor the legislative history provides guidance

with respect to how the FDIC is to balance the various requirements of

section 7(b) once the DRR is achieved. Nor does the legislative history

provide guidance as to the appropriate timeframe for forecasting losses

so that the reserve ratio can be maintained at 1.25 percent, thereby

ultimately protecting the taxpayers.

It is clear from the legislative history that in enacting FDICIA,

Congress was focused almost entirely on a future where the reserve

ratio would be below the DRR, and that the main goal of S. 543 was to

assure that the taxpayers would not be required to rescue the banking

industry as they so recently had been called upon to do with the S&L

industry. For example, on May 29, 1991, Robert Glauber, Under Secretary

of the Treasury testified before the House Ways and Means Committee

``The Administration's projections are that the BIF will decline

substantially over the next five years, reaching a negative net worth

of over $22 billion by the end of 1996.'' S. Hrg. No. 30, 102d Cong.,

1st Sess. 8 (1991). The report of the Senate Banking Committee on S.

543 cited Congressional Budget Office projections indicating that the

BIF could be recapitalized within 15 years without imposing premiums as

high as 30 basis

[[Page 42684]]

points or more. However, the Committee declined to cap premiums at 30

basis points in the event those projections proved too optimistic. S.

Rep. No. 167, 102d Cong., 1st Sess. 30 (1991). Similarly, Senator John

Kerry expressed concern at the requirement of the bill that the banking

industry pay back any Treasury borrowings, stating that that funding

approach could prove to be impossible. Id. at 230. S. 543 itself

contained an elaborate scheme for expedited congressional authorization

to extend the 15-year recapitalization schedule if necessary.

The following remarks of Congressman Gerald Kleczka during floor

debate in the House reflect the skepticism that banks would be able to

recapitalize the BIF:

Mr. Chairman, one of the Members of the House a short time ago

asked, Where are we going to look to bail out the banks? And he

answered it himself by saying the banks.

Well, I say to you, that is total nonsense. The bank bailout,

whether or not this bill passes, has already started. The bank

insurance fund, the FDIC, is broke. This legislation asks for a $70

billion Treasury loan, which in my estimation will never be repaid

by the banks.

In fact, with the pending bank failures on the line today, it is

estimated that $70 billion will not last through the end of next

year. At that point we are going to loan them more money, more

money, and to say that this is not going to turn into another S&L

crisis, I say, hold on, you are in for a rough ride, because I say

that is what is going to happen.

137 Cong. Rec. H8939 (daily ed. Nov. 1, 1991).

Until now, the Board's discretion in setting risk-based assessments

has been limited by the 23 basis-point minimum average assessment

requirement and the concomitant need to moderate the detrimental impact

of a very high rate on weak institutions which taken together were the

most crucial determinants of the assessment schedule. Once the DRR is

achieved, however, the 23 basis-point minimum requirement will become

inapplicable. Therefore, the Board for the first time must decide as a

prudent insurer what assessment schedule would achieve an effective

risk-based assessment system based on long-term deposit insurance

experience as well as short-term loss predictions consistent with its

obligation to protect the BIF (and ultimately the taxpayers).

The statute is silent with respect to the appropriate timeframe the

Board should use to project losses. Although section 7 requires the

Board to set assessments semiannually to maintain the reserve ratio at

the DRR, to assert--as did various commenters--that the Board is

limited to reviewing the next six months when setting rates is without

foundation in either the statute or the legislative history and

disregards the recent past history of bank failures, the rapid

deterioration and collapse of seemingly healthy institutions, and the

increasing volatility of numerous economic factors affecting both the

industry and the BIF. Moreover, such a position ignores Congress'

primary goal in enacting FDICIA--that the fund not decrease to the

point that taxpayer funds are needed to rescue the BIF.

In fact, the legislative history of FDICIA indicates that Congress

intended the FDIC to set premiums in much the same manner as private

insurance companies, where the insured's premium is a function of the

risk posed to the insurer. For example, in his opening remarks at the

Senate Banking Committee hearing on risk-based premiums on April 19,

1991, Senator Alan Dixon stated, ``I think it is fundamentally

important for the Federal Deposit Insurance Corporation to price its

product like every other insurance company--that is, according to risk

of loss.'' S. Hrg. No. 355, 102d Cong., 1st Sess. 1197 (1991).

Accordingly, the Board believes it appropriate as part of its process

for setting assessments to look to the practices of private sector

insurers to inform its decisionmaking. As manager/administrator of the

deposit insurance fund, the Board has a fiduciary obligation to manage

the fund in a prudent manner to preserve the fund on behalf of both the

banking industry and the taxpayers, who are ultimately the insurers of

last resort for the banking industry.

Standard private sector insurance involves one party, the insured,

who seeks protection against a specific risk by paying a premium to

another party, the insurer, who agrees to compensate the insured for

any losses resulting from the risk specified in the contract.\9\

However, federal deposit insurance differs from private insurance

because deposit insurance is intended to be a pledge or guarantee meant

to convey confidence to prevent the spread of bank runs and because it

provides an unconditional guarantee to depositors that their insured

funds are safe regardless of the risks undertaken by an insured

depository institution.\10\

\9\ Congressional Budget Office, Reforming Federal Deposit

Insurance, (1990) xv.

\10\ Id. at xvi.

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Private insurance companies typically operate through a self-

sustaining fund by basing the level of capital needed in reserve on

actuarial assessments of past and potential losses. The insurer charges

different premium rates to different clients based upon an assessment

of their risk of loss.\11\ Private insurers uniformly underwrite

specified risks that are similar in quality and variety by using

historical data to set premium rates to cover long-term costs of any

given risk category.\12\ In banking, however, the difficulty for the

deposit insurer is determining when the revenues of any particular

category are sufficient to cover expected costs.\13\ In casualty

insurance, for example, the events insured against are independent of

each other and are uncorrelated over time. By contrast, bank failures

are not evenly distributed or uncorrelated but tend to be clustered as

a function of economic conditions or shocks.\14\ This makes it more

difficult to set rates so that the long-run revenues are sufficient to

cover the long-run costs of each risk category.

\11\ Id. at 28.

\12\ Id.

\13\ FDIC, A Study of the Desirability and Feasibility of a

Risk-Based Deposit Insurance Premium System, A report pursuant to

Section 220(b)(1) of the Financial Institutions Reform, Recovery,

and Enforcement Act of 1989, submitted to the United States Congress

by the Federal Deposit Insurance Corporation, at 11 (1990).

\14\ Id.

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In the absence of legislative direction, the Board believes that it

is compelled to give effect to the statutory directive to have a

meaningful risk-based assessment system and the directive to set rates

to maintain the reserve ratio at the DRR, by balancing the various

statutory factors which underlie those directives and which,

ultimately, are the determinants of an appropriate assessment schedule.

Neither of these directives, nor any single statutory factor, may be

given effect at the expense of the other. Thus, for example, in

weighing the requirement to set assessments at a target DRR, the

``revenue needs of the fund'' factor may not be interpreted, as has

been suggested by some commenters,\15\ in such a way that the risk-

based assessment system becomes meaningless when the fund attains the

DRR.

\15\ See, discussion of ABA comments at Section IV.A., infra.

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D. Rebates

The Board is adopting its proposed interpretation that the Board

lacks rebate authority because that authority was eliminated by

Congress in FDICIA. As discussed below, this position is based on: (1)

The statutory history of sections 7 (d) and (e); (2) the fact that

Congress repealed the rebate authority in section 7(d); and (3) the

legislative history indicating that Congress

[[Page 42685]]

intended that lower rates would be the substitute for rebates.

In the proposal, the Board reviewed the FDIC's authority to provide

rebates of amounts by which the reserve ratio exceeds the DRR based on

both former and current statutory provisions in FDI Act sections 7(d)

and 7(e) respectively, and the legislative history of those provisions.

Based on that review, the Board proposed a statutory interpretation

that: (1) The FDIC's authority to provide rebates was eliminated by

Congress in FDICIA effective with the adoption of the statutorily

mandated risk-based assessment system on January 1, 1994; and (2)

section 7(e) does not provide rebate authority, but rather pertains to

the method of providing refunds of assessment overpayments.\16\

\16\ Section 7(e) provides that the FDIC:

(1) May refund to an insured depository institution any payment

of assessments in excess of the amount due to the Corporation or (2)

may credit such excess toward the payment of the assessment next

becoming due from such depository institution and upon succeeding

assessments until the credit is exhausted.

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In FDICIA, Congress provided for establishment of a risk-based

assessment system that, after the DRR was achieved, would provide the

FDIC with the flexibility to set a broader range of assessment rates.

In 1990, Congress had already provided the FDIC with the authority to

adjust assessment rates upward to ensure that the BIF received

sufficient revenue.\17\ In FDICIA, Congress intended that same rate

adjustment authority to operate in lieu of providing rebates in the

event that the established rates resulted in collection of excess

assessment revenue. Therefore, Congress eliminated the rebate

provisions of section 7(d) in their entirety as being obsolete because

the ability to adjust rates would take the place of a rebate mechanism.

This is clear from the following discussion of section 212(e)(3) in the

Senate Report on S. 543:

\17\ See, discussion of Assessment Rate Act, infra, note 4.

Section 212(e)(3) replaced current section 7(d) with a new

section 7(d) recodifying current section 7(b)(9). The deleted text,

providing for assessment credits to insured institutions when

deposit insurance fund reserve ratios exceed designated reserve

ratios, is obsolete in light of the standards for establishing

assessments set forth in new section 7(b)(2)(A)(i) [setting rates to

maintain at the DRR]. Under section 7(b)(2)(A)(i), funds that, under

current section 7(d), would have been rebated to insured depository

institutions through assessment credits will now be rebated through

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reduced assessments.

138 Cong. Rec. S2073 (daily ed. Feb. 21, 1992). (Emphasis added.)

In response to the Board's proposed interpretation regarding the

FDIC's rebate authority, a total of 482 respondents generally disagreed

with the FDIC's position; one trade association appeared to accept the

interpretation and it requested a legislative change to restore the

rebate authority. Of those in disagreement, seven BIF members, four

trade associations and one individual explicitly disagreed with that

interpretation, asserting that the FDIC did, in fact, have authority to

provide rebates. A total of 400 commenters (383 BIF members, 3 SAIF

members, 12 trade associations and 2 other commenters) largely without

any discussion of the FDIC's legal authority, indicated that when the

BIF reserve ratio exceeds the DRR as a result of assessment income, the

FDIC should return to BIF members all assessments above 1.25 percent

because those funds could be better used servicing local communities.

In addition, 48 commenters (46 BIF members and 2 trade associations)

responded that assessment income in excess of 1.25 percent other than

the $1,000 statutory semiannual minimum should be returned. Finally, 21

commenters (15 BIF members and 6 trade associations) asserted that when

the reserve ratio exceeds the DRR, the FDIC should return both

assessments and investment income above 1.25 percent.

Based on its interpretation of the DRR as a ceiling on the amount

of funds that may lawfully be retained in the BIF, the ABA has asserted

that all amounts (including investment income) in excess of a reserve

ratio of 1.25 percent must be rebated to the industry. The ABA has

argued that returning excess reserve amounts by means of lowering

subsequent assessments is merely one method of accomplishing the

statutory intent to return funds; where that method does not suffice to

accomplish that goal, the statute should be interpreted to find an

alternative method. Accordingly, notwithstanding the statutory history

of section 7(e) and the repeal of section 7(d), it argued that the FDIC

could rely on an interpretation of the plain meaning of section 7(e) to

implement the statutory purpose.

The New York Clearing House (Clearing House) stated that the FDIC

has rebate authority pursuant to the plain meaning of section 7(e) and

that there is no legislative history to indicate that that section

should be interpreted other than in accordance with a plain reading.

Further, the rebate authority is particularly important because the

Clearing House does not believe that the FDIC will be able to maintain

the reserve ratio at 1.25 percent by semiannual rate adjustments only,

without some form of rebate mechanism. Citicorp also criticized the

FDIC's interpretation, indicating that the inability to provide rebates

when the reserve ratio exceeds 1.25 percent makes the determination of

the proper rate schedule all the more critical.

The IBAA similarly argues that, without such authority, the FDIC

will be unable to manage the BIF at the DRR as required and that the

FDIC's interpretation ignores the discretion to set rates given to it

by Congress in connection with the risk-based assessments system. The

IBAA and the Bankers Roundtable noted that although the authority of

section 7(d) was removed, the statute does not expressly prohibit the

FDIC from providing rebates pursuant to some other authority.

The Board is unconvinced by the alternative interpretation offered

by commenters that rebate authority exists in section 7(e), which

authorizes the FDIC to refund or credit to an insured institution any

assessment payment in excess of the amount due to the FDIC. The Board

does not believe it can ignore unequivocal action by the Congress to

eliminate rebate authority by, in effect, re-creating that authority

through a new interpretation of section 7(e) absent some indication in

the legislative history that Congress intended section 7(e) 18 to

serve as a substitute for section 7(d) of the FDI Act.

\18\ Section 7(e) has been consistently interpreted by the FDIC

since 1950 to provide authority to refund erroneous overpayments of

assessments. The FDIC has never interpreted that section as

providing rebate authority.

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Moreover, the FDIC has not located any legislative history

indicating that Congress intended section 7(e) to take the place of

section 7(d). Therefore, for the reasons discussed above, the Board

continues to believe that the better interpretation of the statute is

that the FDIC has no authority to grant rebates and that to do so would

be in violation of the statute and contrary to legislative history.

III. New Rate Spread

The Board is adopting without modification the proposal to increase

the rate spread from 8 basis points in the current assessment schedule

to 27 basis points in the new schedule.

As discussed in Section II.B.2(c), the fundamental goals of risk-

based assessment rates are to reflect the risks posed to the insurance

fund by

[[Page 42686]]

individual insured institutions and to provide institutions with

incentives to control risk taking. In the existing assessment schedule,

the maximum rate spread is 8 basis points. See Table 1. Institutions

rated 1A pay an annual rate of 23 basis points while institutions rated

3C pay 31 basis points. There is a substantial question as to whether 8

basis points represents a sufficient spread for achieving these goals.

BILLING CODE 6714-01-P

[[Page 42687]]

[GRAPHIC][TIFF OMITTED]TR16AU95.000

BILLING CODE 6714-01-C

[[Page 42688]]

As discussed in the proposal, the current assessment rate spread

for BIF institutions has been criticized widely by bankers, banking

scholars and regulators as overly narrow, and there is considerable

empirical support for this criticism. Using a variety of methodologies

and different sample periods, the vast majority of relevant studies of

deposit insurance pricing have produced results that are consistent

with the conclusion that the rate spread between healthy and troubled

institutions should exceed 8 basis points.19 While the precise

estimates vary, there is a clear consensus from this evidence that the

rate spread should be widened.

\19\ For a representative sampling of academic studies on this

issue, see Estimating the Value of Federal Deposit Insurance, The

Office of Economic Analysis, Securities and Exchange Commission

(1991); Berry K. Wilson, and Gerald R. Hanweck, A Solvency Approach

to Deposit Insurance Pricing, Georgetown University and George Mason

University (1992); Sarah Kendall and Mark Levonian, A Simple

Approach to Better Deposit Insurance Pricing, Proceedings,

Conference on Bank Structure and Competition, Federal Reserve Bank

of Chicago (1991); R. Avery, G. Hanweck and M. Kwast, An Analysis of

Risk-Based Deposit Insurance for Commercial Banks, Proceedings,

Conference on Bank Structure and Competition, Federal Reserve Bank

of Chicago (1985).

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FDIC research likewise suggests that a substantially larger spread

would be necessary to establish an ``actuarially fair'' assessment rate

system. Insurance premiums are actuarially fair when the discounted

value of the premiums paid over the life of the insurance contract is

expected to generate revenues that equal expected discounted costs to

the insurer from claims made by the insured over the same period. A

1994 FDIC study used a ``proportional hazards'' model to estimate the

expected lifetime of banks that were in existence as of January 1,

1993. The study estimated the actuarially fair premium that each bank

must pay annually so that the cost of each bank failure to the FDIC

would equal the revenue collected through insurance assessments. The

estimates indicated a rate spread for 1A versus 3C institutions on the

order of magnitude of 100 basis points.20

\20\ See, Gary S. Fissel Risk Measurement, Actuarially Fair

Deposit Insurance Premiums and the FDIC's Risk-Related Premium

System, FDIC Banking Review (1994), at 16-27, Table 5, Panel B.

Single-copy subscriptions of this study are available to the public

free of charge by writing to FDIC Banking Review, Office of

Corporate Communications, Federal Deposit Insurance Corporation, 550

17th Street, N.W., Washington, D.C. 20429.

---------------------------------------------------------------------------

In the proposal, the Board expressed concern that rate differences

between adjacent cells in the current matrix do not provide adequate

incentives for institutions to reduce the risk they pose to BIF by

improving their condition, which is a fundamental goal of risk-based

assessments. Larger differences are consistent with historical

variations in failure rates across cells of the matrix, viewed in

connection with the preponderance of evidence regarding actuarially

fair premiums.21 The precise magnitude of the differences is open

to debate, given the sensitivity of any estimates to small changes in

assumptions and to selection of the sample period. However, the Board

believes that larger rate differences between adjacent cells of the

matrix are warranted. Accordingly, the Board proposed for comment an

increase in the spread between the lowest and highest rates in the

assessment schedule to 27 basis points from the current 8 basis point

spread.

\21\ Id., at Tables 2 and 5.

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Of the 357 commenters (332 BIF members, 4 SAIF members, 16 trade

associations and 5 other organizations/individuals) who addressed the

issue of the increased spread, 298 respondents supported the proposal.

Of those, 217 respondents (including 9 trade associations and 203 BIF

members) expressly approved of the increase to 27 basis points; an

additional 70 respondents (including 1 trade association and 69 BIF

members) indicated support for increasing the spread but didn't

specifically mention the proposed increase to 27 basis points. Forty

commenters (including 4 trade associations and 35 BIF members)

expressed the opinion that the proposed spread was too great; by

contrast, 12 commenters, all of whom were BIF members, thought the

spread should be wider than proposed. Finally, 18 commenters (including

2 trade associations and 12 BIF members) expressed reservations about

the increased weight given to the subjective supervisory ratings in

determining an institution's risk classification.

Among the commenters supporting the proposed increase, numerous

respondents expressed the opinion that the proposal would provide BIF

members with greater incentive to control risk while at the same time

rewarding well-managed institutions for limiting risk. For example,

Banc One Corporation noted, ``Prudent, healthy institutions should not

have to pay for ill-advised activities and high-risk institutions.''

The New York Clearing House stated that ``the larger spread is more

actuarially equitable, in that it reduces the burden that the strongest

institutions must bear to support the weakest.'' The Bankers Roundtable

indicated its support for incentive-based regulation coupled with a

strong spread between the lower- and higher-risk institutions. The

Roundtable noted that ``risk-based premiums should address all the

strengths of an institution, not merely capital. As the schedules now

contemplate and as other regulators who examine and evaluate

institutions assess, strong management and strong internal risk control

systems are important as well.''

Forty commenters opposed the proposed 27 basis-point spread. For

example, the ABA asserted that the current spread should be retained

because it provides a strong incentive for banks to move into the

lower-risk categories as evidenced by the increase in 1A institutions

between 1993 and 1995 from 60 percent to 90 percent of the industry.

The ABA also indicated concern about the emphasis on the supervisory

rating because of its subjectivity. America's Community Bankers

expressed similar reservations and indicated that it would be better to

give more weight to capital because it is both a more objective and

more controllable factor. Orange National Bancorp commented that

examiners have too much individual discretion in assigning risk

classifications. It recommended that a standard model for such

evaluations be implemented if one is not already in place. The

California Bankers Association (CBA) opposed the increased spread

because of the belief that it too closely correlates with local

economic conditions that are beyond the control of the institution.

Thus, adverse local economic conditions may result in higher risk

classifications at a time when the institution can least afford it. The

CBA further noted that ``[a] primary objective of deposit insurance

should be to spread uncontrollable risk among similarly situated

institutions. To impose additional premiums when that risk is actually

realized is analogous to charging a person a universal health insurance

rate, and then increasing that rate when the person actually becomes

sick and requires care.'' (Emphasis in original.) The CBA proposed as

an alternative a narrowing of the spread to mitigate the penalties

imposed on a bank for falling into a higher risk category due to the

effects of a local economic downturn.

By contrast, the twelve commenters who indicated that the spread

should be wider indicated that the proposed assessment schedule did not

adequately reflect the true risk to the BIF. Several commenters raised

concerns about the insufficient distinction between the riskiness of

low-risk banks. For example, Wells Fargo Bank stated that

[[Page 42689]]

``[n]inety percent of banks should not be included in the lowest risk

category.''

A number of commenters indicated support for the proposal that the

nine-cell matrix should remain in place pending an in-depth review of

the risk classification system. Expressing its support for deposit

insurance rates as an appropriate incentive for banks to control risky

activities, the IBAA recommended that the FDIC implement the premium

reduction before considering modifications to the nine-cell matrix. The

ABA indicated that bankers support keeping the risk classification

system simple, and it would not, therefore, support any revisions to

the matrix involving the creation of more categories or a new, super-

capitalized category. In Citicorp's view, ``any change in the number of

cells will create disputes while producing very little additional

equity'' without greater explanation of the underlying rationale for

any increase. Citicorp called for frequent reviews an institution's

risk so that the risk classification is based on current evaluations.

The Board is adopting the proposed increase in the spread from 8 to

27 basis points without modification. Having carefully considered the

comments on the proposal, the Board nonetheless continues to believe

that the assessment rate matrix should be adjusted in the direction of

an actuarially fair rate structure, as described above. In addition, as

in the proposal, the Board has decided not to adopt changes to the

nine-cell assessment rate structure at this time. Accordingly, as

proposed, the new rate matrix retains the existing nine cells.

While the Board appreciates the concern expressed in the comments

regarding the additional weight placed on supervisory evaluations as a

result of the increased rate spread, the use of such evaluations as a

risk measure is well-established. Historically, deteriorations in

supervisory ratings are associated with a substantially higher

incidence of failure.

When the Board adopted the existing 8-point rate spread in 1992, it

expressed the conviction that widening the spread was desirable but

declined to do so because of the potential hardship for troubled

institutions and possible additional losses for the insurance

fund.22 At that time, however, a wider rate spread would only have

been accomplished through an increase in the assessment rate paid by

weaker institutions. In contrast, under the new schedule the Board is

now adopting, the rate spread will be widened by means of a reduction

in the rates applicable to stronger institutions.

\22\ In the FDIC's 1993 proposal for the existing statutorily

mandated risk-based premium system, the Board sought comment on

whether the assessment rate spread embodied in the existing system,

i.e., 8 basis points, should be widened. Of the 96 commenters

addressing this issue, 75 favored a wider rate spread. In adopting

the existing 8 point rate spread in 1993, the Board expressed its

conviction that widening the rate spread was desirable in principle,

but chose to retain for the time being, the 8 point rate spread. The

Board expressed concern that widening the rate spread while keeping

assessment revenue constant, might unduly burden the weaker

institutions which would be subject to greatly increased rates.

However, the Board retained the right to revisit the issue at some

future date. 58 FR 34357 (June 25, 1993).

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Under the new schedule, all BIF-insured institutions except those

with assessment risk classification 3C will enjoy a reduction in their

assessment rates, with a consequent beneficial impact on earnings and

capital. The only adverse effect on earnings and capital conceivably

could result from the increase in the rate spread from 8 basis points

to 31 basis points. Under the current assessment schedule, weaker

institutions are competing with institutions that pay an assessment

rate of 23 basis points. Under the new schedule, where all but

institutions in the 3C category will pay reduced rates, the weaker

institutions will be competing with a large group of BIF members that

will be paying a rate of only four basis points. In principle, if the

BIF members classified as 1A pass along their reduced assessments to

their customers, the weaker institutions may be forced to pay more for

deposits or charge less for loans to stay competitive.

The FDIC performed an analysis simulating the effects of the wider

rate spread on all insured institutions under the assumption that the

weaker institutions would have to absorb the entire increase in spread

in the form of a higher cost of funds. The result was that apart from

institutions that have already been identified by the FDIC's

supervisory staff as likely failures, the wider spread is expected to

have a minimal impact in terms of additional failures.

A widening of the spread to 27 basis points is consistent with the

implications of the best empirical evidence on this issue and with the

Board's previously stated conviction. Moreover, the increased

differences between adjacent cells in the matrix provides additional

incentive for weaker institutions to improve their condition and for

all institutions to avoid excessive risk-taking. This is consistent

with the Board's desire to create adequate incentives through the

assessment rate structure to encourage behavior that will protect the

deposit insurance fund against excessive losses.

Nonetheless, the Board remains unwilling at this time to increase

further the maximum rate other than by means of the adjustment factor

discussed below, without further study regarding the overall insurance

pricing structure for the industry.

IV. New Assessment Schedule

In light of its interpretation of section 7(b) discussed above and

based on its consideration of the required statutory factors, the Board

is adopting in the final rule its proposed new assessment rate schedule

ranging from a rate of 4 basis points for institutions with a risk

classification of 1A to 31 basis points for institutions rated 3C (see

Table 1) and, as noted above, a spread of 27 basis points. As discussed

below, the adoption of this schedule reflects the Board's determination

that the FDIC's insurance responsibilities require it to look beyond

the immediate timeframe in estimating losses and the revenue needs of

the fund, and to take account of the variability of the factors

influencing the BIF reserve ratio, variability that can be substantial

even within a single assessment period.

A. Comments

The FDIC received 1401 comments (1364 BIF members, 11 SAIF members,

14 trade associations and 12 other organizations or individuals) that

either expressed general support for the proposed decrease in rates or

specifically mentioned support for the proposed schedule of 4 to 31

basis points. However, 347 commenters (320 BIF members, 3 SAIF members,

22 trade associations, 1 organization and 1 individual) expressed

dissatisfaction with the rates specifically. As discussed in Section

II.B.1, most of the commenters argued that the proposed rates are too

high to comply with the FDIC's requirement to maintain the BIF at its

DRR. Eleven commenters stated that the proposed schedule was too low.

Finally, forty commenters (7 BIF members, 23 SAIF members, 1 trade

association and 9 other organizations/individuals) urged the FDIC not

to decrease BIF rates.

Those commenters who were satisfied with the proposed rate

structure generally were pleased that they will enjoy the benefit of a

very large decrease in assessments in the near future and expressed

pride that the BIF will be recapitalized much earlier than expected and

without taxpayer assistance.

[[Page 42690]]

Of the commenters who indicated that the proposed assessment

schedule was too high, 115 (including 12 trade associations and 102 BIF

members) stated specifically that the rate either for institutions with

a 1A risk classification or for all institutions should be 0 basis

points (the ABA position); 87 commenters (including 2 trade

associations and 84 BIF members) asserted that the rate for 1A

institutions should be decreased to 2 basis points (the IBAA position).

Many cited the statements in the proposal indicating that it was likely

that the BIF reserve ratio could be maintained at 1.25 percent in the

second half of 1995 solely as a result of investment income as support

for their position that the proposed rate schedule is too high, at

least with respect to 1A institutions.

In fact, the ABA argued that when the BIF does not need assessment

income to remain at 1.25 percent, the FDIC may not assess any BIF

members, i.e., assessing a zero rate on all such regardless of risk.

The ABA's position is that the risk-based assessment spread is

determined independently from the revenue needs of the fund; that

spread is simply moved up or down in order to generate the required

revenue to offset expenses, i.e., the rate schedule itself is solely a

function of the amount of revenue needed to maintain the BIF at 1.25

percent. Thus, where no income is needed, there is no need for the

risk-based assessment system. However, the ABA argues that beneficial

incentives for bank performance will still operate because riskier

banks will not know in advance whether the revenue needs of the BIF

will require imposition of an assessment, so unless they improve their

performance, they will face the prospect of paying higher assessment

rates than their peers. Moreover, they argue that a zero rate serves as

an incentive to manage banks well.

Some commenters also criticized the historical basis on which

expected losses are forecast by the FDIC. Several commenters asserted

that the statute requires the Board to set assessments based on the

revenue needs of the BIF for the succeeding six month period, not on a

historical basis. Finally, many commenters indicated that the use of

the historical average fails to take into account the fundamental

changes that have occurred since FDICIA, i.e., least-cost resolutions,

prompt corrective action, cross-guaranty authority, and depositor

preference statutes.

On the other hand, some of the commenters argued that the BIF rates

should not be decreased at all. Among these was the Center for Study of

Responsive Law/Essential Information, which thought the loss

projections were completely inadequate for the potential risks facing

the industry. They interpreted the statutory DRR as a floor, and urged

the FDIC to establish a higher range for the DRR with a target average

of 1.63 percent using 1.25 percent as the floor and 2.0 percent as the

ceiling.

In view of the numerous comments on the propriety of the average

rate implied by the proposal, the Board finds it appropriate to provide

here a detailed summary of the analysis and reasoning that served as a

basis for its decision to adopt the proposed rate schedule in the final

rule. Accordingly, this section considers in depth the analysis

supporting the approach adopted by the Board for satisfying the

requirements to maintain the reserve ratio at 1.25 percent and to have

a risk-based assessment system.

B. Review and Balancing of Statutory Factors

As discussed in Section II, pursuant to the directive of section

7(b)(1) to have a risk-based assessment system and the directive of

section 7(b)(2)(A)(ii) to maintain the reserve ratio at the DRR, the

Board is required to review and weigh the following factors when

establishing an assessment schedule:

(1) The probability and likely amount of loss to the fund;

(2) Case resolution expenditures and income;

(3) Expected operating expenses;

(4) The effect of assessments on members' earnings and capital;

(5) The revenue needs of the fund; and

(6) Any other factors that the Board may deem appropriate.

1. Analytical Framework

(a) Summary. In principle, the requirements to maintain the reserve

ratio at the DRR and to have assessments for individual institutions

based on risk to the fund complement and reinforce each other.

Maintenance of a particular reserve ratio requires the FDIC to attempt

to match fund revenue and expense over time. An important element of

that requirement comes from a risk-based assessment system that equates

revenue with ``expected cost'' over a long period. The estimation of

expected insurance losses is thus important both in the structuring of

risk-based assessments and maintaining a given reserve ratio over a

period of time.

The following subsections outline the FDIC's analysis and the use

of that analysis for informing the decision of the Board regarding BIF

assessment rates. Subsection (b) discusses in general terms the

selection of a time period over which to estimate insurance losses, and

the relation of this question to the statutory requirements to maintain

the BIF at its target DRR and to have a system of risk-based

assessments. Subsection (c) describes the increase in volatility of key

economic variables characteristic of the post-1980 period and reviews

the increase in banking-industry risk that also occurred during this

period. The basic conclusion is that a return to the relative stability

of the 1950-1980 period is unlikely and, thus, the FDIC is likely to

experience continued volatility in insurance losses in the years ahead.

Subsection (d) provides a brief discussion of the risks in banking

today and a historical perspective on the risks associated with highly

rated and well capitalized banks. The information presented indicates

that a meaningful assessment of risks posed by insured institutions

must look beyond the immediate timeframe. Subsection (e) discusses the

average assessment rates that would have maintained the fund at a given

reserve ratio at various times in the FDIC's history, and sets out how

it would be destabilizing to the banking industry for the FDIC to

attempt to maintain continuous equality of the BIF to its DRR by trying

to equate revenues and expenses during every six-month period. The

analysis indicates that an average effective assessment rate in the

range of four to 13 basis points would have matched revenue and expense

over most of the FDIC's history. It also indicates that recent changes

in business conditions, including several statutory changes, strongly

suggest that a rate at the low end of that range should be adopted.

Subsection (f) discusses the implications of volatility in insured

deposits for the rate-setting process.

(b) The Planning Horizon for Rate Setting. An important part of the

rate-setting process is the desire to equate revenues with expenses

over a period of time. The answer to the question ``over what period of

time?'' has important ramifications for the way the FDIC sets

assessments and manages its reserve ratio, as well as for the banking

industry. This matching of revenue and expense encompasses most of the

statutory factors required to be considered by the Board in that it

seeks to determine the revenue needs of the fund in light of the

probability and likely amount of losses, expected case resolution

expenses and income, and the amount of operating expenses.

Purely for expositional purposes, it is useful to consider an

extreme case where revenues and expenses are balanced over a very short

horizon, say

[[Page 42691]]

one day. One could imagine that each morning banks would be billed

electronically for the cost of any bank failures expected to occur that

day. In this extreme case, the BIF could be managed to within very

close to its DRR on a virtually continuous basis (ignoring

uncertainties about the level of insured deposits).

In this example the FDIC's insurance function would be that of

allocating current costs across banks through billings and collections

on a pay-as-you-go basis. The word ``insurance'' is normally associated

with the concept of spreading risk. This risk spreading can be over

time, across the insured parties, or both, depending on the type of

insurance. A pay-as-you-go system in which the cost of the insured

event is borne entirely at the time the event occurs does not

accomplish the spreading of risk over time.

Whether the spreading of risk over time is important in banking is

an empirical question that is discussed below in subsection (e) of this

section. If the FDIC had operated on a yearly pay-as-you-go basis

during the post-1980 period, for example, assessments would have been

as high as 62 basis points in 1991. Rates at that level would have

adversely affected the earnings and capital of the industry and the

soundness of the FDIC insurance fund.

In general, one can say that the shorter the planning horizon over

which one tries to equate revenues and expenses, the more certainty

there will be about loss estimates, and the easier it will be to manage

the reserve ratio to any given level. On the other hand, the shorter

this planning horizon, the less the FDIC's business would resemble the

risk-spreading function of an insurer and the greater the risk that

high and volatile insurance premiums would adversely affect the

earnings and capital of the banking industry and the soundness of the

insurance fund.

Attempting to equate revenues and expenses over a longer period has

the risk-spreading advantages classically associated with insurance.

Assessments are collected when times are good to pay for problems when

times are bad, and there can be some measure of stability to the

assessment rates, thereby avoiding the adverse effects on bank earnings

and capital discussed above. Under this regime, the intent would be to

maintain the insurance fund at the DRR on average over the planning

horizon, rather than continuously.

The choice of a planning period for equating revenues and expenses

is therefore a fundamental decision for the FDIC as manager and

fiduciary of sound deposit insurance funds. Relevant to the judgment is

whether it is consistent with the FDIC's mission that the entire cost

of banking problems be paid by the banking industry during the

assessment period in which they occur. As discussed below, the use of a

pure pay-as-you-go approach is inconsistent with the FDIC's mandate to

charge assessments that reflect the probability and like amount of loss

to the insurance funds because this approach ignores the risks that

exist beyond a six-month horizon. In addition, the pay-as-you-go

approach, if adopted as a general rule, would result in adverse effects

on bank earnings and capital during times of stress in banking.

(c) Increased Economic Volatility and Bank Stability. The economic

environment affecting banks began to change during the 1970s and the

pace of change accelerated during the 1980s. The result is that banking

is a riskier and more demanding business today than ever before. This

subsection documents some major changes in the banking environment that

have occurred during the last 15 to 20 years. Part (i) contains a

discussion of the increased volatility of certain key macroeconomic

variables that directly and indirectly affect banking risk. Part (ii)

contains a more specific discussion of developments in the financial

services industry and in the characteristics of insured banks.

(i) Key economic variables. For about twenty years beginning in the

early 1950s, the U.S. economy and the commercial banking industry

enjoyed a period of relative stability. Key economic variables such as

inflation, interest rates and exchange rates displayed remarkable

stability, and in part as a result, bank failures were few. This period

of stability began to end in the 1970s.

An important change in the nature of economic volatility resulted

from the movement to a floating exchange rate system from a fixed rate

system that occurred in 1973. As international trade expanded in the

post World War II era, the maintenance of fixed exchange rates required

adjustments to trading relationships and domestic economic policies of

trading nations that were not optimal. Thus, the change substituted

volatility in interest rates and commodities prices for increased

volatility in exchange rates. However, as explained below, subsequent

events have tended to increase the volatility in other financial and

economic variables beyond the levels experienced in the fixed exchange

rate environment.

With the Smithsonian Agreement (see Figure 1 for the German mark

(DEM) and Japanese yen (JPY) in 1971 to 1973), exchange rates among all

of the major currencies were realigned and permitted to float without

upper and lower bounds. These developments predictably gave rise to

considerably greater exchange rate volatility at a time when world

trade was also expanding rapidly.

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[[Page 42693]]

Markets for forward and futures exchange rate contracts developed

in order for firms to manage more effectively exchange rate risks and

markets for combined currency and interest rate swaps have followed

this trend. The Chicago Mercantile Exchanged formed the International

Money Market (IMM) and began offering the first foreign exchange

futures contract on major currencies in 1972.\23\ The volatility that

gave rise to these contracts can be seen in Figure 2, comparing the

volatility in the dollar exchange rate with the German mark and the

Japanese yen.\24\

\23\ These contracts were also the first financial futures

contracts offered in the U.S.

24 Volatility is measured in each period as the standard

deviation of the monthly percentage change of each exchange rate.

The standard deviation is measured using observations over the prior

six months.

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[[Page 42695]]

Since 1970, there have been periods of relative calm in exchange

rates (e.g., 1976-77) interspersed with periods of substantial

volatility, some considerably extended, and periods with volatility

varying among currencies. For example, the first oil embargo in 1973

resulted in increased volatility for the mark, but a decrease for the

yen. In the European Monetary System currency crisis in late summer and

early fall of 1992, the yen actually showed a decline in volatility,

but the mark, the most appreciated European currency at the time,

showed a sharp increase in volatility. More recently, the change in

monetary policy by the Federal Reserve in February 1994 resulted in a

depreciation of the dollar relative to the mark, increased volatility

in exchange rates, and sharp increases in foreign and domestic interest

rates (see Figure 2 for exchange rate volatility from January to May

1995). Without the well-developed markets for forwards and futures

contracts for foreign exchange, such volatility would be less

manageable and would significantly lessen foreign trade.

A second source of volatility, not unrelated to the adoption of a

floating exchange rate system, is in the levels and term structure of

interest rates. Foreign exchange rates and interest rates among

countries are related through arbitrage opportunities to borrow and

lend in different currencies. Banks are active participants in foreign

markets and international deposit and loan markets for their own

account and those of their customers. Banks that are lending and

borrowing abroad face risks of exchange rate changes that affect the

dollar value of their loans and liabilities denominated in foreign

currencies. The interest rates banks and other investors are willing to

accept for loans and pay on borrowings are affected by their

expectations of future exchange rates. The more uncertain and volatile

are exchange rates, the greater the opportunities for losses and the

greater the need for hedging assets and liabilities from exchange rate

risk. The greater volatility experienced in exchange rates is

translated into greater interest rate volatility as banks and other

investors attempt to hedge positions in loan and deposit markets and

arbitrage among interest rate differentials that arise among debts

denominated in various currencies. An example of the relationship of

the link between exchange rate volatility and interest rate volatility

was during the period of adjustment in 1973 to the new exchange rate

regime and the rise in U.S. interest rate volatility during this same

period (see Figure 1 for the rapid appreciation of the DEM and JPY

during this period and interest rate volatility in Figure 3).

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[[Page 42697]]

Volatility in the level of interest rates can be seen in Figure 3

for the 3-month T-bill rate (the darker connected line). In this

figure, the dark bars are periods of recession (peak to trough) as

designated by the National Bureau of Economic Research. Volatility is

presented in this figure as the computed likelihood of being in a high

interest rate volatility regime (the light, spiked areas measured on

the left axis); that is, a period where the standard deviation of daily

interest rate changes is statistically expected to be higher than

average. As can be seen, the period of the 1960s was relatively calm

with the exception of the recession of 1969 to 1970. After this period,

interest rates became more volatile, as did general economic activity.

During the 1970s, several oil embargo shocks in 1973 and 1978 resulted

in accelerating inflation and contributed considerably to interest rate

volatility. The Federal Reserve dramatically changed monetary policy in

October 1979 by switching from an interest rate target to a monetary

aggregates target, such as nonborrowed reserves, with the objective of

reducing inflation. The result of this policy was a highly volatile

interest rate period from October 1979 until late 1982.25

Correspondingly, it was about this time when the volume of interest

rate futures contracts was beginning to grow on the Chicago Mercantile

Exchange and the Chicago Board of Trade.26 Soon afterwards, over-

the-counter interest rate forwards and swaps were introduced on a

meaningful scale and their growth accelerated by 1986, coinciding only

incidentally with the period of the collapse in world oil prices.

\25\ The stock market crash in October 1987 is also clearly

evident in Figure 3 with a period of high volatility occurring at

this time. What is also interesting is that a period of high

interest rate volatility occurred in early 1987 coinciding with an

apparent change in monetary policy. It is important to note that

changes in monetary policy tend to evoke periods of greater interest

rate volatility and possible adverse effects on bank earnings.

\26\ The development of interest rate futures contracts was

given a boost in 1974 with the creation of the Commodity Futures

Trading Commission. The CFTC was given exclusive responsibility over

futures markets. As a by-product of this legislation, cash

settlement of futures contracts was permitted. The provision of

federal law superseded state laws that prohibited contracts settled

in cash because they were considered wagers and were treated as

illegal gambling.

---------------------------------------------------------------------------

Another source of volatility is in the term structure of interest

rates. The importance of the volatility in the term structure stems

from the need to have accurate estimates of future short-term interest

rates. Expected future short-term interest rates form the basis for the

valuation of interest rate swaps, forward, futures, and options on

future interest rates, and options on futures contracts. Volatility in

the term structure can also give rise to volatility of bank earnings to

the extent that banks face gaps between interest sensitive assets and

interest sensitive liabilities. The causes of this volatility in

interest rates have been linked to expectations of changes in future

short-term interest rates fed by the volatility in the rate of

inflation and inflation expectations. Figure 4 shows the 3-month T-bill

rate and the difference between the 10-year T-bond rate and the 1-year

T-bond rate as a proxy for the steepness in the yield curve. It is

clear that the yield curve has been volatile and at times has become

inverted (periods such as 1972 through late 1974, and early 1978

through 1982 when the 1-year T-bond yield was higher than the 10-year

yield), requiring considerable caution in funding long positions in

long-term assets or fixed rate assets with short-term, variable rate

liabilities. In periods of substantial volatility in the term

structure, simple methods of interest rate risk management, such as

duration gap management, become incomplete methods of managing interest

rate risk.

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[[Page 42699]]

A final source of increased volatility is that arising from general

economic activity. To a considerable extent, the volatility in general

economic activity can be traced to real shocks, such as the oil

embargoes of the 1970s, wars, dissolution of the Soviet Union, and the

fiscal and monetary policies of the major industrialized nations. These

shocks have caused considerable volatility in commodity prices and real

output. The record inflation of the 1970s was followed by a period of

slower inflation, but greater commodity price volatility. Figure 5

presents commodity prices (CRB Raw Materials Spot Prices) compared with

the Consumer Price Index (All Urban Areas). Although the oil shocks of

the 1970s resulted in considerable inflation in commodities and

consumer prices, the volatility that also resulted in commodity prices

has not abated during the 1980s or early 1990s.

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[[Page 42701]]

The volatility of prices and general economic activity can have a

substantial impact on banking performance, as the experience of the

1980s makes clear. The sectoral inflation and subsequent deflation of

agricultural prices in the late 1970s and early- to mid-1980s was a

major contributor to the failure of hundreds of agricultural banks.

Similarly, the boom and subsequent collapse of oil prices caused

significant problems for banks in states whose economies had important

energy sectors. The real-estate problems of the 1980s and early 1990s

caused major problems for many banks. These problems can be traced in

part to unanticipated changes in regional economic conditions, as the

behavior of real estate prices departed sharply from past patterns

(Figure 6).

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[[Page 42703]]

(ii) Trends in the banking industry since 1980. Since 1980, the

business of banking has changed considerably. As noted above, risks

have increased as interest rates, exchange rates and commodity prices

have become more volatile and as economic shocks have been transmitted

more widely via the globalization of markets. Meanwhile, competition in

the financial marketplace has greatly intensified. The traditional

intermediation function of banks has assumed a smaller role in

aggregate economic activity, largely because financial and

technological innovations have increased the funding options for firms

that formerly were restricted to bank loans. Banks have been forced to

seek new sources of income and to implement untested business

strategies, and such experimentation carries inherent risks.

The major trends affecting the banking industry since 1980 are

summarized in an accompanying series of charts. The charts emphasize

the substantial increase in banking risk as compared to earlier

periods, and the role of competition and innovation as forces driving

this development.

Dramatic evidence that banking has become riskier is observable in

the annual rates of bank failure (Figure 7). While annual bank failures

exceeded single digits only rarely between 1940 and 1980, failure rates

rose rapidly thereafter to a record high of 200 in 1988 (221 including

assistance transactions). A similar picture emerges from the data on

FDIC insurance losses relative to insured deposits (Figure 8). Annual

insurance losses were extremely low on average prior to 1980, less than

half a basis point of insured deposits, and were quite stable; losses

for the 1980-94 period exceeded 14 basis points on average and were

highly variable.

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[[Page 42706]]

Net loan charge-offs as a percent of average total loans have

trended upward since the early 1970s, accelerating rapidly beginning in

1980 and reaching a peak of 1.57 percent in 1991 (Figure 9). Over the

same period, bank stocks substantially underperformed the S&P 500

(Figure 10).

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[[Page 42709]]

The effects of increased competition and innovation are

inextricably intertwined. Both have played a role in the banking

industry's declining share of financial-sector assets since 1980

(Figure 11). Innovation has transformed the commercial paper market

into a formidable competitor for banks. Figure 12 shows that the ratio

of commercial paper outstanding to bank commercial and industrial loans

(C&I loans) has increased four-fold since 1980. Meanwhile, the ratio of

finance-company business loans to bank C&I loans has more than doubled

over the same period, and most of this growth has occurred since 1982

(Figure 13).

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[[Page 42713]]

The growth in securitization of loans represents another dimension

of the competitive pressures faced by banks. By increasing the

liquidity and efficiency of the credit markets, securitization produces

a narrowing of the spreads available to traditional lenders such as

banks and thrifts. The outstanding example of this process occurs in

the mortgage market, where the proportion of consumer mortgages pooled

for resale (or ``securitized'') has grown from about 10 percent in 1980

to more than 40 percent as of year-end 1993 (Figure 14).

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[[Page 42715]]

On the liability side, banks have faced increasing competition from

many nonbank financial institutions. Foremost among these have been the

money-market mutual funds (MMMFs), which rose from obscurity in 1975 to

prominence by 1981: the ratio of MMMF balances to comparable commercial

bank deposits (small time and savings deposits) was virtually zero

during the mid-1970s, but reached nearly 35 percent by 1981 (Figure

15). After declining briefly to 25 percent in the early 1980s, this

ratio grew steadily thereafter, exceeding 40 percent by the end of

1993.

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[[Page 42717]]

These developments have forced changes in the business strategies

of commercial bankers. Faced with diminished opportunities for C&I

lending, banks have shifted into real-estate lending in recent years

(Figure 16). This new portfolio composition has exacerbated the adverse

effects on banks of downturns in regional real estate markets.

Noninterest income also has become more important for bankers (Figure

17), and off balance-sheet activities have grown substantially in

recent years. The dollar amount of these activities was roughly 60

percent of the comparable amount for on balance-sheet activities in

1984, but this figure grew to 120 percent by the end of the decade.

Taken together with the periodic, large-scale movements in and out of

particular lending markets (LDC, HLT, commercial real-estate

development, and the like), these portfolio shifts suggest that many

banks have embarked on a widening search for new profit opportunities

in response to the competitive pressures undermining their traditional

niche in the financial marketplace.

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[[Page 42720]]

Innovations in information systems technology have effectively

integrated network development, telecommunication technology and

computing into a tool for expansion in twenty-four hour global trading,

market monitoring and sophisticated risk management. These developments

have permitted a global markets presence for major banking companies

and have expanded the opportunities for global market developments in

exchange-traded products and dealing in over-the-counter bilateral

contracts. Advances in telecommunications, in particular, have

permitted the rapid and inexpensive transmission of market information

and the globalization of markets. The result may be a banking

environment that is more complex and less transparent than at any time

since the 1920s.

At present, there is no indication that the forces discussed above

are abating. Nor are there reasons to expect that the degree of

competition or the pace of innovation will reverse course in the

foreseeable future. To the contrary, the relentless decline of

information costs in recent years augurs, if anything, stronger

competition for banks, occurring on new fronts and originating from new

sources. In view of these realities, it is reasonable to assume that

the FDIC will continue to experience a substantial amount of volatility

in insurance losses in the coming years.

(d) Risks in Banking Today. The banking industry at present is in

good health, with high earnings, high capitalization, and few problem

institutions. The risks that currently confront the industry do not

pose an imminent threat, but several general concerns can be

identified.

Market participants continue to anticipate significant volatility

in interest rates and exchange rates, as evidenced by the explosive

growth of derivative instruments expressly designed to hedge against

this volatility. Competition from nonbank sources remains intense and

likely will increase for the reasons cited above, putting pressure on

banks' interest-rate margins. The industry is restructuring through

mergers and is adjusting to the changing rules with respect to

interstate banking and branching. While these developments in general

bode well for the deposit insurance funds, major structural changes in

an industry usually are accompanied by some costly mistakes by

individual firms. Finally, the possibility of an economic slowdown

later in 1995 and 1996,27 reports of potential problems in the

agricultural sector, and continuing economic weakness in California

must be considered.

\27\ The consensus forecast reported by Blue Chip Economic

Indicators as of July 1995 was for slower GDP growth in late 1995

and 1996 than prevailed in 1994.

Some historical perspective is also useful for assessing current

banking risks. Information problems are inherent in evaluating the

condition of banking institutions, and the uncertainty is compounded in

attempting to identify emerging problems. History shows that a

substantial percentage of bank failures have been unanticipated as

early as two years prior to failure. The FDIC examined 1,286 bank-

failure cases from 1982-1994 in order to determine the CAMEL ratings of

the institutions prior to failure. Table 2 displays the relevant

results. Two years prior to failure, almost 47 percent of the

institutions had composite CAMEL ratings of 1 or 2.28 Of the 1,189

cases for which CAMEL ratings could be obtained 3 years prior to

failure, over 60 percent of the institutions (which accounted for

almost 75 percent of failed-bank assets in the sample) were rated 1 or

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2.

\28\ Not all institutions were examined precisely two years

prior to failure. The results reflect the ratings in the examination

database as of two years prior, but the date of examination varies

across institutions. Nonetheless, these data represent the current

rating of the institution as of two years prior to failure, based

upon the latest examination.

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[[Page 42722]]

Similarly, Figure 18 indicates that the vast majority of banks that

failed between 1987 and 1994 were well capitalized three years prior to

failure. Moreover, 80 percent of failed-bank assets over this period

originated from institutions that were well or adequately capitalized

three years before failure.

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[[Page 42724]]

The track record of models developed to project bank failures

illustrates the same issue: these models exhibit a high degree of

imprecision. Table 3 presents annual forecast errors from two types of

failure projection models employed by the FDIC. The ``actuarial'' model

groups banks into 25 cells of a matrix based on current performance

characteristics. Failures are projected for each cell according to the

three-year historical failure experience of banks with characteristics

matching the criteria for the cell. Projections for a one-year horizon

are based on the one-year failure experience of banks that would have

qualified for the cell at any time during the previous three years,

those for a two-year horizon are based on the two-year historical

experience, and so on. The one- and two-year projection errors for

failed-bank assets from this model over the past 7 years have been

large by any reasonable standard, regularly exceeding 50 percent and

occasionally approaching 100 percent. The ``pro forma'' model has fared

no better. This model assumes that an institution's current portfolio

composition will be maintained in the future and that the recent

relationship between nonperforming loans and subsequent charge-offs

will prevail as well. The one-and two-year projection errors from this

model have never been lower than 80 percent.

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Similar conclusions emerge from an analysis of the failure

projections made by the FDIC's supervisory staff. These projections

list, on an individual bank basis, the banks with over $100 million in

assets that are deemed to have a greater than 50 percent probability of

failing during each of the next eight quarters. Since 1992, assets in

failing institutions have ranged from 18 percent to 80 percent of those

listed as being likely to fail within one year under this approach. The

forecast errors are substantially higher when a two-year horizon is

used. This illustrates that predicting the identity and timing of the

failures of specific institutions is even more difficult than

predicting the total volume of assets in failed banks.

In short, indicators such as CAMEL ratings, capital categories, and

failure projections appear to be driven largely by the current

condition of insured institutions and not by underlying risks that are

difficult to identify and predict. The record shows that these risks

cannot be ignored even for institutions that currently appear healthy.

These findings serve to emphasize that any meaningful assessment of the

risks posed to the deposit insurance funds by insured institutions must

look beyond a six-month period.

Another important point that emerges from Table 3 relates to the

volatility of forecasting errors in predicting bank failures. While the

total volume of assets in banks failing from 1988 through 1994 was just

13.7 percent shy of the total amounts projected over that period using

a one-year forecast horizon, the errors in any given year were much

larger, ranging from an 86 percent overprediction for 1992 to a 59

percent underprediction in 1987. Thus, while it may be possible to

discern trends in bank failures over a reasonably long period, there is

considerable uncertainty regarding the timing of these failures.

(e) Rate Setting--Historical Context and Current Conditions. The

considerations described in the subsection (c) suggest that financial

services and banking experienced a fundamental increase in risk during

the 1980s, and that the pressures that brought about this increase in

risk have not abated. Banking today remains a highly competitive and

demanding business. Opportunities for geographic expansion and

diversification will most likely increase the safety-and-soundness of

the banking system but, like other fundamental changes in the ``rules

of the game'' governing depositories, could result in costly mistakes

by some institutions.

This section provides information on the FDIC's loss experience

since 1935. Information on hypothetical ``breakeven assessments'' is

provided for two scenarios: Pay-as-you-go versus a long-run average

cost assessment structure. Information on the pay-as-you-go approach is

used to evaluate the desirability of that approach, with the result

being an unfavorable evaluation.

Table 4 shows assessments that would have been needed to maintain

the BIF at 1.25 percent of insured deposits on an annual basis since

1949. These account for the effects of investment income, operating

expenses and changes in the amount of insured deposits in the banking

system. Figure 19 shows that these ``pay-as-you-go'' assessments are

much more volatile than the actual assessments that were charged by the

FDIC, because of the tendency of bank failures to be ``bunched'' as a

function of economic shocks, rather than being evenly distributed over

time.

[[Page 42727]]

Table 4.--BIF Premium Rates and Ratios: Effective, Pay-As-You-Go, and Fixed Rate Scenarios

----------------------------------------------------------------------------------------------------------------

Effective Pay-as-you-go Fixed assessments

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Year Assessment Assessment 4.5 bp

rate BIF ratio rate BIF ratio ratio 7 bp ratio 13 bp ratio

----------------------------------------------------------------------------------------------------------------

1994................. 23.60 1.15 -16.7 1.25 -0.42 1.42 1.16

1993................. 24.40 0.69 -37.3 1.25 -0.56 1.11 0.80

1992................. 23.00 -0.01 -10.8 1.25 -0.92 0.60 0.23

1991................. 21.25 -0.36 62.8 1.25 -0.93 0.44 0.04

1990................. 12.00 0.21 49.0 1.25 -0.05 1.20 0.76

1989................. 8.33 0.70 17.7 1.25 0.59 1.75 1.26

1988................. 8.33 0.80 32.3 1.25 0.78 1.89 1.33

1987................. 8.33 1.10 8.9 1.25 1.16 2.21 1.60

1986................. 8.33 1.12 16.9 1.25 1.23 2.18 1.54

1985................. 8.33 1.19 8.8 1.25 1.38 2.31 1.60

1984................. 8.00 1.19 10.2 1.25 1.44 2.32 1.56

1983................. 7.14 1.22 7.6 1.25 1.52 2.35 1.54

1982................. 7.69 1.21 9.8 1.25 1.57 2.38 1.49

1981................. 7.14 1.24 -1.4 1.25 1.65 2.45 1.46

1980................. 3.70 1.16 6.5 1.25 1.56 2.27 1.29

1979................. 3.33 1.21 -1.3 1.25 1.60 2.32 1.21

1978................. 3.85 1.16 3.3 1.25 1.52 2.19

1977................. 3.70 1.15 4.1 1.25 1.51 2.16

1976................. 3.70 1.16 5.8 1.25 1.52 2.15

1975................. 3.57 1.18 3.3 1.25 1.54 2.17

1974................. 4.35 1.18 6.2 1.25 1.54 2.14

1973................. 3.85 1.21 5.5 1.25 1.57 2.17

1972................. 3.33 1.23 6.4 1.25 1.60 2.19

1971................. 3.45 1.27 2.4 1.25 1.65 2.24

1970................. 3.57 1.25 5.5 1.25 1.63 2.19

1969................. 3.33 1.29 0.3 1.25 1.66 2.22

1968................. 3.33 1.26 7.5 1.25 1.60 2.12

1967................. 3.33 1.33 6.1 1.25 1.68 2.20

1966................. 3.23 1.39 6.0 1.25 1.73 2.24

1965................. 3.23 1.45 4.7 1.25 1.79 2.30

1964................. 3.23 1.48 3.7 1.25 1.81 2.31

1963................. 3.13 1.50 0.7 1.25 1.82 2.30

1962................. 3.13 1.47 2.4 1.25 1.77 2.21

1961................. 3.23 1.47 3.3 1.25 1.75 2.16

1960................. 3.70 1.48 1.6 1.25 1.75 2.14

1959................. 3.70 1.47 -0.1 1.25 1.71 2.07

1958................. 3.70 1.43 4.5 1.25 1.64 1.96

1957................. 3.57 1.46 1.7 1.25 1.66 1.95

1956................. 3.70 1.44 1.2 1.25 1.62 1.88

1955................. 3.70 1.41 2.0 1.25 1.58 1.80

1954................. 3.57 1.39 2.3 1.25 1.54 1.73

1953................. 3.57 1.37 0.9 1.25 1.51 1.67

1952................. 3.70 1.34 2.5 1.25 1.46 1.57

1951................. 3.70 1.33 3.0 1.25 1.43 1.51

1950................. 3.70 1.36 11.5 1.25 1.41 1.45

1949................. 8.33 1.57 0.4 1.25 1.57 1.57

----------------------------------------------------------------------------------------------------------------

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[[Page 42729]]

Pay-as-you-go assessments have the undesirable effect that the

banking industry must pay the most for its insurance at precisely the

time it can least afford it. For example, as indicated in Figure 20, in

1988 through 1991, when the banking industry was experiencing its

greatest difficulties since the 1930s, pay-as-you go assessments would

have drastically reduced bank income. In 1988, median bank return-on-

assets (ROA) would have been reduced by 37 percent; in 1989 by 19

percent; in 1990 by 57 percent; and in 1991 by 71 percent. These sharp

reductions in income could have significantly impaired the recovery and

recapitalization of the banking industry and increased the FDIC's costs

from bank failures. Thus, the Board's obligation to consider the impact

on bank earnings and capital of an assessment rate structure would

virtually preclude it from adopting a rigid pay-as-you-go rate-setting

approach.

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[[Page 42731]]

For these reasons, there is likely to be considerable pressure

brought to bear on the FDIC during periods when the banking industry is

under stress not to charge assessments high enough to maintain the DRR.

If the reserve ratio falls below the DRR, the FDIC is required by law

to increase assessments to regain the DRR within one year. However, if

the drop is such that the DRR cannot be attained after a year of

increased assessments, the FDIC is mandated to impose assessments

equivalent to a minimum average weighted rate of 23 basis points which

would be in effect until the DRR is attained--potentially for up to 15

years. While the requirement to charge an average rate of at least 23

basis points is less onerous for the industry and the insurance fund

than a strict pay-as-you-go rule, it may be cause for concern. Although

BIF institutions absorbed the increase in effective annual assessment

rates to 23 basis points as of 1992 with no known direct casualties, it

is notable that a strong recovery was emerging in the banking industry

at the same time, in part because of a more favorable interest rate

environment. It is questionable whether such increases could have been

absorbed without a discernable adverse impact during a downturn or at

the trough of a banking cycle such as 1988-89.

A strict pay-as-you-go approach results in substantial adverse

effects on industry earnings and capital at the time the industry can

least afford additional costs. It ignores the real risks that exist in

banking beyond a six-month time horizon and, thus, appears to conflict

with the Board's duty to consider fully the probability and likely

amount of insurance losses and case resolution expenditures. Further,

because such an approach would likely be abandoned during times of

banking difficulties, it is likely to result in periodic episodes where

the fund falls below its DRR and the FDIC is operating in

``recapitalization mode,'' or in even more severe straits.29 For

these reasons, the Board regards the pay-as-you-go approach as

seriously flawed.

\29\ For example, in 1991 the BIF reserve ratio reached a

negative 0.36 percent of insured deposits.

---------------------------------------------------------------------------

The alternative basis for setting BIF assessments, and the basis

adopted by the Board, is to look beyond the immediate time frame in

estimating the revenue needs of the fund. For illustrative purposes

Table 4 shows the assessments that would have equated revenues to costs

over certain periods in the FDIC's history. The analysis begins at

year-end 1949, after the FDIC had retired its initial Treasury capital

contribution. From 1950 through 1980, a period of relative stability in

banking compared to more recent times, an assessment rate of roughly

4.5 basis points would have balanced costs and revenues over the

period. From 1980 through 1994 the required assessment rate would have

been roughly 13 basis points, and for the entire 1950-1994 period the

required rate would have been seven basis points. Under all these

scenarios the reserve ratio of the fund would have fluctuated

considerably and would have been ``maintained'' in a long-run average

sense.

The FDIC's historical loss experience thus suggests that an

effective assessment in the range of 4.5 basis points to 13 basis

points would be expected to balance revenues and expenses over a

relatively long period of time. There are several factors that cause

the Board to adopt an effective average assessment rate at the low end

of the range suggested by historical experience.

Recent developments suggest that the FDIC's expected cost resulting

from a given level of banking risk may be smaller now than it was in

the 1980s. Prompt corrective action has strengthened the regulators'

hands in closing nonviable institutions promptly. The least-cost

resolution process mandated by FDICIA has reduced the number of

instances where the FDIC is permitted to protect uninsured depositors

in bank failures. The nationwide depositor preference statute has

placed the FDIC and the depositors ahead of all nondeposit creditors in

receiverships of failing banks, although it remains to be seen whether,

as the markets gain more experience with depositor preference, bank

liabilities will shift as a bank approaches failure in ways that would

reduce the FDIC's cost savings. Sectoral price inflation and the danger

of subsequent deflation appear less of a concern now than in the 1980s.

While underlying risks are still significant, the banking industry will

face any new episode of problems with higher capital ratios than it

enjoyed in the 1980s. Finally, the BIF balance and reserve ratio are

much higher than they were during most of the 1980s, resulting in

higher levels of investment income that will reduce the effective

assessment rate needed to balance revenues and expenses.

The net result of these changed conditions is that a purely

historical analysis of long-term expected costs should be substantially

tempered by a judgment about the effect of these changes on expected

losses. Since we have not had a significant episode of bank failures

since the imposition of these changes, there is little empirical basis

for speculation about the magnitude of cost reductions likely to occur.

Nevertheless, it is the judgment of the Board that an effective

assessment rate for the banking industry at the lower end of the 4.5 to

13 basis-point range suggested by historical experience is likely to

cover expected losses to the BIF over a reasonable time horizon. The

Board expects that this judgment will be revisited on a semiannual

basis in light of changing conditions.

(f) Rate Setting--Planning for Volatility in Insured Deposits. The

FDIC sets assessment rates to be effective for a subsequent six-month

period. An element of uncertainty about the reserve ratio that will

result from a given rate schedule arises from the possibility for

insured deposits to grow or shrink over the six-month period at rates

different than originally expected.

Figures 21 and 22 provide some perspective on this issue. Figure 21

displays the frequency of various percentage changes in insured

deposits at commercial banks occurring during six-month intervals,

quarterly from 1984 through the first quarter of 1995. The impacts of

these percentage changes on the BIF reserve ratio, applied to an

assumed BIF ratio of 1.25 percent of BIF-insured deposits as of the

first quarter of 1995, are displayed in Figure 22.

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[[Page 42733]]

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[[Page 42734]]

The 1984-1985 period described in Figures 21 and 22 can be divided

into two subperiods. From 1984 to mid-1991, there was healthy,

sustained growth in insured deposits. Since mid- to late 1991, however,

insured deposits have for all intents and purposes not grown at all. It

is uncertain how much the dramatic reduction in assessments resulting

from the new rate schedule in the final rule will stimulate growth in

BIF-insured deposits.

The experience of the 1984-1995 period indicates that changes in

insured deposits can subject the BIF reserve ratio to considerable

variation relative to the DRR. For example, during three six-month

periods since 1984, insured deposits increased at rates that if applied

today, would reduce the BIF reserve ratio by more than eight basis

points, to less than 1.17 percent, other things constant.

The import of these facts is that if the FDIC set assessment rates

so that the BIF were expected to end the subsequent six-month period at

the DRR, based on a modest expected growth in insured deposits, then

actual growth in insured deposits could deviate sufficiently from

expected growth that the FDIC could end the assessment period with a

reserve ratio of considerably less than the DRR. This attests to the

difficulty of precisely managing the reserve ratio and suggests

maintenance of the DRR may require the FDIC to allow for the

possibility of unexpected changes in insured deposits.

2. Summary of Application of Statutory Factors

(a) Financial Factors: Probability and Likely Amount of Insurance

Losses; Case Resolution Expenditures and Income; Operating Expenses;

Revenue Needs of the Fund. As discussed in Section IV.B.1 above, the

Board believes that its insurance responsibilities require it to look

beyond the immediate timeframe in setting assessment rates. The

probability and likely amount of losses and case resolution expenses

are determined by risk factors that operate over a far longer horizon

than six months. Accordingly, the Board's duty to assess risk-based

assessments in accordance with these statutory factors require it to

price the risk of adverse events that may occur beyond the immediate

horizon.

Projected income and expense for the second half of 1995 are

presented in Table 5. Total income from assessments and investments of

about $1.1 billion is expected to exceed total insurance losses and

operating expenses in the range of $302 million to $352 million. The

BIF reserve ratio is expected to be between 1.27 percent and 1.31

percent at June 30, 1995, depending on the timing of the proposed

refund of overpayments and the growth in insured deposits during the

second quarter.

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BILLING CODE 6714-01-C

The BIF reserve ratio as of December 31, 1995, will be dependent on

a variety of factors, none of which can be predicted with certainty at

this time.

[[Page 42736]]

The Board considered a range of assumptions about these factors in an

effort to estimate the BIF reserve ratio at year-end 1995 that would

result from the new rate schedule. Insurance losses and increases in

the reserve for future failures during the second half of 1995 were

assumed to range from a negative $200 million to a positive $600

million. This range reflects the possibility that institutions for

which the FDIC has established a loss reserve would recover during the

second half of 1995 or, alternatively, that currently unidentified

institutions would develop problems during this period that would

require the FDIC to establish a loss reserve. The range of variability

considered for this factor is modest relative to the variations in the

reserves that have occurred in recent years. BIF-insured deposits are

assumed to grow at an annualized rate of between zero and six percent

during the last three quarters of 1995. While six percent growth

appears unlikely at this time, it is not outside the range of

historical experience, as indicated in Figure 21. Under these

assumptions, the BIF reserve ratio would be between 1.24 percent and

1.36 percent at year-end 1995.

The rule adopted by the Board thus is expected to result in an

excess of revenue over expense for the second half of 1995. The Board

based this decision on two general factors. First is the requirement to

set assessment rates to account for the probability and likely amount

of insurance losses. As just discussed, this requires the Board to

consider the possibility of adverse events that may not occur during

the immediate timeframe. The FDIC's experience during two very

different times--the relatively stable period from 1950 to 1980, and

the more volatile post-1980 period--suggests that an assessment in the

range of 4 to 13 basis points would, on average, meet the revenue needs

of the fund over a long period of time in light of the probability and

amount of losses, case resolution expenditures, income, and operating

expenses that have characterized the FDIC's past experience.

The Board has considered other factors governing the probability

and likely amount of losses and case resolution expenditures that are

likely to occur in future years. As discussed in more detail in Section

IV.B.1(e), these include recent statutory changes (prompt corrective

action, least-cost resolution and depositor preference), the currently

reduced likelihood of problems arising from sectoral inflations and

subsequent deflations, and the high capital ratios generally prevailing

in banking. These factors tend to reduce the probability and likely

amount of losses and caused the Board to adopt an effective assessment

rate at the low end of the historically suggested range.

Another factor driving the selection of an assessment rate at the

low end of the historical range was the investment income deriving from

the current BIF balance. The investment income of the BIF will be

substantially higher than it was during most of the last ten years.

This reduces the need for assessment income to meet the revenue needs

of the insurance fund. It is anticipated that the Board will revisit

this issue on a semiannual basis by considering further adjustments in

assessment rates if the BIF continues to grow in light of the Board's

obligation to maintain the BIF at the target DRR.

The second general factor governing the selection of the rates

adopted by the Board is the need to allow for the possibility of

unanticipated changes in insured deposits or loss reserves that may

occur during a semiannual period. The BIF ratios projected to occur at

midyear and year-end 1995, respectively, are projections based on a

reasonable range of estimates of the growth in BIF insured deposits

during 1995. It must be emphasized that the level of BIF-insured

deposits for neither date are known at this time. As discussed in

subsection (f) above, based on the historical variability in semiannual

changes in insured deposits, it is conceivable that the BIF ratio might

not reach the DRR at year-end even under the new rate schedule. As

indicated in Figure 22, it is within the range of the historical

experience of the past 10 years that insured deposits can change by

enough in a six-month period to move the BIF reserve ratio by as much

as eight basis points.

Similarly, in evaluating the probability and likely amount of

insurance losses, the Board considered the uncertainty inherent in

predicting the level of the FDIC's reserve for future failures. This

reserve is determined using a methodology agreed to by the U.S. General

Accounting Office and is intended to estimate the cost of failures that

can reasonably be anticipated over a subsequent 18-month period. The

provision for insurance losses has displayed considerable volatility in

recent years, ranging from a $15.4 billion addition to the reserve in

1991 to a $7.7 billion reduction in the reserve in 1993.

The net effect of variability in insured deposits and losses, and

additions to the loss reserve, can be of considerable practical import

in light of the Board's duty to maintain the DRR. For example, as

indicated in Table 5, an annualized growth in BIF insured deposits of

six percent over the last three quarters of 1995, in conjunction with

insurance losses and additions to reserves of $600 million during the

second half of 1995, would result in the BIF falling short of the DRR

at year-end. The new rate schedule provides a level of comfort that

unanticipated changes in insured deposits will not cause the BIF to

fall below the DRR.

(b) Impact on Earnings and Capital. In deciding against adopting a

strict pay-as-you-go policy for setting assessments, the Board

considered the adverse effects on banking industry earning and capital

of such a policy. As discussed in subsection (e), such a policy has the

undesirable effect of sharply increasing the assessment costs of

insured institutions at a time when they can least afford such

increases. Subsection (e) describes how a pay-as-you-go policy applied

during the 1980s would have had a severe adverse impact on the earnings

and capital of the banking industry during the years 1988-1991.

The Board considered the near-term impact of adopting the 4 to 31

basis point rate matrix. Because assessment rates for most BIF members

will decline under the new assessment schedule, the impact on earnings

and capital will be positive. Lower assessment costs will reduce

expenses by approximately $4.4 billion per year. Based on the

industry's year-end 1994 average tax rate of 33 percent, after-tax

profits will increase by approximately $3 billion per year. BIF members

may pass some portion of the cost savings on to their customers through

lower borrowing rates, lower service fees, and higher deposit rates.

Their ability to do so will be affected by factors such as the level of

competition faced by banks. As discussed in Section III above, the

potential adverse effect on weaker institutions resulting from the

decreased assessment rate paid by their competitors is likely to be

minimal in terms of the number of additional failures.

(c) Other Factors the Board Deems Appropriate. When setting

assessment rates to maintain the reserve ratio at the DRR, section

7(b)(2)(A)(ii) authorizes the Board to consider ``any other factors

that the Board of Directors may deem appropriate''. The statute does

not limit the discretion of the Board to determine those factors which

are appropriate to consider in the rate-setting process. Although the

statute specifically lists other criteria, such as case resolution

expenditures, which must be included in its determination, the Board is

free to take into account economic and other data which it deems

relevant. Accordingly, the Board has incorporated

[[Page 42737]]

into its balancing process a review of variables particular to the

financial services industry such as interest and exchange rate

volatility and nonbank competition as well as projections for the

economy in general.

The proposal reviewed the propriety of including under this factor

consideration of the competitive disparity arising from the

differential in assessments for members of the BIF and SAIF. The Board

is adopting without change the interpretation of ``other factors''

which was set forth in the proposal.

The proposal discussed the interplay of the ``other factors''

provision with section 7(b)(2)(B), which requires the Board to set

semiannual assessments for members of each fund ``independently'' from

semiannual assessments for members of the other insurance fund. Read

together, these provisions do not specifically prohibit Board

consideration of the impact of BIF rates on SAIF members as long as the

rates are set independently. However, the proposal indicated the

potential conflict with section 7(b)(2)(A)(i) which requires the Board

to set rates to maintain the BIF reserve ratio. If the Board were to

take into consideration the impact on the SAIF when it set BIF rates

(i.e., setting BIF rates higher than otherwise necessary to minimize

the disparity between BIF and SAIF rates), and, as a result, the

reserve ratio continued to increase in excess of the DRR, it might be

considered a violation of the statute.

Although a total of 591 commenters indicated that the Board should

not take into account the impact on the SAIF and its members when

setting the rates for BIF members, few of those comments provided any

legal analysis. Those that did, (including the ABA, ABA State

Association Division, IBAA, Citicorp, New York Clearing House, the

California Bankers Association, GreenPoint Bank and Bank of Boston)

concurred with the analysis set forth in the proposal. A number of

these commenters indicated that ``other'' factors should be interpreted

only to encompass factors that relate to the condition of the BIF.

By contrast, the Savings Association Insurance Fund Industry

Advisory Committee (SAIFIAC) indicated that the FDIC ``has an equal

duty and responsibility to each Fund * * * [which] dictates that any

proposal to lower BIF rates must be coupled formally with both a

regulatory determination that the SAIF PROBLEM MUST BE DEALT WITH, and

a proposal for a solution.'' (Emphasis in original.) SAIFIAC further

indicated its belief that the proposal declined to take into account

the impact on SAIF because that impact could not be quantified.

The Board continues to believe that setting BIF rates higher than

otherwise would be warranted would likely cause an increase in the BIF

reserve ratio above in the DRR in violation of the statute.

Accordingly, the Board is adopting the interpretation of ``other

factors'' as proposed.

3. Conclusions

The principal conclusion of the foregoing analysis is that the

exercise of the FDIC's insurance responsibilities require it to look

beyond the immediate period in pricing risk. A pure pay-as-you-go

pricing system can expose the banking industry to unduly high and

volatile insurance assessments that can adversely affect the soundness

of the banking system and the BIF. Moreover, the FDIC's experience with

bank failures makes it clear that a meaningful evaluation of the risk

associated with even highly rated and well-capitalized institutions

must look beyond a six-month period. Accordingly, the Board will

undertake to look beyond the immediate period in determining the

revenue needs of the BIF.

The second principal conclusion is that the Board's duty to

maintain the DRR as a target requires it to take account of the

substantial variability of a number of factors influencing the revenue

needs of the fund. Insured deposits display enough variability to cause

the BIF reserve ratio to fluctuate considerably relative to the DRR.

Insurance losses are extremely difficult to predict, and the FDIC's

policy of establishing loss reserves for failures expected to occur as

much as 18 months in the future magnifies the problem of prediction.

This is because the prediction of the BIF's income in the second half

of 1995 necessarily must allow for the possibility of changes in the

reserve for future failures that may not occur until year-end, for

failures anticipated to occur through mid-1997.

In light of the imprecision inherent in the measurement of banking

risk--whether through examination ratings, capital measures or models

used to project bank failures--the Board does not intend to specify a

time period over which the FDIC will attempt to estimate its expenses

for the purpose of setting assessment rates. Instead, rate-setting will

be undertaken as an evolving process in which historical analysis

tempered by informed judgment about current conditions, including the

investment income deriving from the balance in the BIF, is revisited on

a semiannual basis.

The historical analysis presented above suggests that an effective

average assessment rate in the range of 4.5 to 13 basis points would be

expected to meet the revenue needs of the fund over the very long term.

The factors outlined above have convinced the Board that the lower end

of the assessment range is reflective of the risks currently facing the

BIF and, moreover, takes adequate account of the variability in insured

deposits, losses, and additions to the reserve for future failures that

may affect the adequacy of the BIF relative to the DRR over the second

half of 1995. The Board is, accordingly, adopting the 4 to 31 basis

point rate matrix as originally proposed.

In adopting the 4 to 31 basis point rate schedule, the Board

emphasizes its expectation that the rate-setting process going forward

will evolve continuously. For example, even assuming no change in the

FDIC's risk exposure to potential bank failures, the attempt to balance

revenues and costs over a longer horizon is consistent with semiannual

adjustments to reflect changes in the fund balance. Increases in the

BIF balance, due either to shocks or to favorable industry conditions

that persist beyond the period that could be expected, would increase

investment income and make it less likely that the fund would fall

short of the DRR over any given future horizon, other things equal. In

response to this, and depending upon other relevant factors, the Board

may deem it appropriate in subsequent semiannual periods to reduce

assessments below the level that previously had been expected to be

necessary to meet the revenue needs of the funds.

V. Application and Adjustment of New Assessment Schedule

The Board is adopting the proposal to apply the new assessment rate

schedule in the semiannual period during which the DRR is achieved,

with refunds of any overpayments from the first day of the month

following the month in which the DRR is achieved. Under the final rule,

overpayments will be refunded with interest at a rate that corresponds

to the rate of interest earned by the FDIC on the overpayments.

In addition, the Board is adopting, with two clarifications, the

proposed process for modifying the new assessment rate schedule by

means of an adjustment factor of 5 basis points, as necessary to

maintain the reserve ratio at 1.25 percent without the necessity of

engaging in separate notice-and-comment rulemaking proceedings for each

adjustment.

[[Page 42738]]

A. Semiannual Period During Which DRR Is Achieved

In the proposal, the Board interpreted the language and legislative

history of section 7(b)(2)(E) of the FDI Act--that is, the requirement

to assess a minimum average rate of 23 basis points--as prohibiting the

Board from decreasing the assessment rates paid by BIF members until

after the FDIC is able to confirm that the reserve ratio has, in fact,

reached the DRR, regardless of projections for BIF recapitalization. If

the Board were to decrease the rates based on projections for BIF

recapitalization, the reserve ratio would ``remain'' below the DRR at

the time of the Board's action and the minimum-assessments provision of

section 7(b)(2)(E) would continue to apply. Accordingly, the Board

proposed to decrease assessment rates once the FDIC has been able,

based on a review of the relevant quarterly reports of condition (call

reports) necessary to determine the amount of estimated insured

deposits,30 that the DRR has in fact been achieved. The rate

reduction would be effective on the first day of the month following

the month in which the DRR is attained. The Board further proposed to

refund, with interest from the date the new rates take effect, any

overpayments of assessments under the new rate schedule resulting from

the delay in confirming attainment of the DRR.

\30\ The reserve ratio is the dollar amount of the BIF fund

balance divided by the estimated insured deposits of BIF members.

Although data for the fund balance is accounted for on a monthly

basis, the amount of estimated insured deposits is based on data

from the quarterly reports of condition (call reports). Because it

appears that the BIF recapitalized in the second quarter, the amount

of estimated insured deposits would be determined by the information

on the June call reports which are due on July 30 (or for some

institutions, August 14). Due to the customary time lag involved in

verifying the information from the call reports, it is probable that

the determination that the DRR has been achieved will not be made

until mid-September. Moreover, because the fund balance is

determined only on a monthly, rather than a daily basis, the date on

which the Board ascertains that the DRR has been attained is the

last day of the month.

---------------------------------------------------------------------------

Of the 356 commenters addressing these elements of the proposal,

343 expressed support for the process of implementing the new rates and

refunding overpayments. Of these, 286 respondents expressly mentioned

support for refunding the assessments with interest from the date the

new rates become effective.

One commenter thought that, for overpayments in the first

semiannual assessment period of 1995, interest should be paid from the

date the FDIC received the assessment in January, rather than from the

date the new rates take effect. Eight commenters disapproved of the

proposed process, believing rates should be dropped more quickly.

Numerous commenters urged that the determination be made as quickly

as possible. For example, the IBAA urged the FDIC to ``make the

necessary determinations as soon as humanly possible so that banks will

enjoy the benefits of premium reduction as early as possible.'' The ABA

urged the FDIC to reduce assessments in the third quarter ``if the

weight of the evidence shows that the BIF will have reached the DRR

before June 30.'' The ABA's position is that waiting for confirmation

of data from the June 30 call reports would merely unnecessarily

complicate the whole process of changing rates.31

\31\ The ABA reiterated this view in a May 19, 1995, meeting

with FDIC staff members, which the ABA had requested to discuss the

proposal. At the meeting, the ABA urged that the FDIC quickly act to

reduce BIF rates to a level no higher than that necessary to bring

the BIF to its DRR. FDIC staff stated the Board's position reflected

in the proposal that the FDIC is precluded from reducing rates until

it has been able to determine that the DRR has in fact been reached.

A summary of the ABA meeting is included in the public comment file

on the proposal, along with other oral and written comments

submitted by the ABA and other respondents.

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The FDIC has carefully considered the comments addressing these

issues. However, the Board continues to believe, given the statutory

language of section 7(b)(2)(E) and the relevant legislative history,

that the FDIC does not have authority to lower assessment rates until

it is certain that the DRR has been attained. Accordingly, as proposed,

the Board has decided not to apply the new rate schedule until the

first day of the month after the month in which the DRR has actually

been reached. In the event it is determined that the DRR has been

reached before the September 30 assessment payment date, as is

expected, the Board will promptly notify BIF members that the amount of

the September 30 payment will be adjusted to reflect the new rate

schedule. In order to avoid any additional overpayment or confusion,

the final rule provides that the FDIC also may delay collection of the

assessments that would otherwise be due on September 30 (or such later

payment date that next follows the effective date of the new rate

schedule). If this occurs, it is very likely that the FDIC would also

delay for a brief period the date of the associated invoice, which is

provided one month prior to the collection date (for example, the

invoice date for a September 30 collection date is August 30).

Because the new assessment rate schedule will apply from the first

day of the month after the month in which the DRR was achieved, it is

likely to be determined that many BIF members have overpaid their

assessments. For example, if the DRR is determined to have been

achieved on May 31 and the new assessment schedule becomes

retroactively effective on June 1, it is likely that all institutions

except those paying the highest rates will have overpaid their

assessment for the first semiannual period of 1995. Similarly, most

institutions will have overpaid their assessments paid on June 30,

1995, for the July-September quarter of the second semiannual period.

In such instances, the FDIC will refund the overpayment with

interest from the effective date of the new assessment rate schedule,

in the case of overpayments for the first semiannual period, and from

the payment date, in the case of overpayments for the second semiannual

period. The FDIC anticipates that it will provide such refunds

electronically by means of credits sent through the Automated Clearing

House (ACH) system, but may do so by check or in more than one payment.

In the case of electronic refunds, it is anticipated that the same

routing transit numbers and accounts used for direct-debit assessments

collection will be used for the electronic credits.

Under the proposal, the interest rate to be paid by the FDIC on

overpayments resulting from a change in the BIF rate schedule would

have been the rate normally applicable to assessment over- or

underpayments in general. However, under the unique circumstances

applicable here, the Board has decided to pay an interest rate that

corresponds to the rate actually earned by the FDIC on the

overpayments. Because the FDIC knew that it was highly likely that the

June 30 collection of assessments at the existing rates would result in

significant overpayments for all but the riskiest institutions, the

Board believes that it is fair and appropriate to pay an interest rate

that returns to the overpaying institutions the amount of interest

actually earned by the FDIC on their overpayments. Accordingly, the

final rule incorporates a special interest rate that is the arithmetic

average of the overnight simple interest rate received by the FDIC on

its U.S. Treasury investments during the relevant period (including

weekends and holidays at the rate for the previous business day). For

example, had the relevant period been June 1995, the applicable rate

would have been 6 percent.

The FDIC recognizes that, once the new assessment rate schedule

becomes effective, insured institutions may have

[[Page 42739]]

questions regarding the application of the new rate schedule and the

mechanics of the refund process, including how and when refunds will be

made. Accordingly, the FDIC will be providing additional, more specific

information regarding these matters to insured institutions.

B. Semiannual Periods after the DRR is Achieved: the Adjustment Factor

As to the semiannual assessment periods after the DRR is achieved

and the new rate schedule has become effective, the Board is adopting

the proposed adjustment factor, with two clarifications.

Under the proposal, the new assessment rate schedule, once

activated, would continue to apply to succeeding semiannual periods,

with modification as necessary in future periods to maintain the

reserve ratio at the target DRR by means of an adjustment factor of up

to and including an aggregate of plus-or-minus 5 basis points or

fraction thereof. The proposal limited to this 5 basis-point range the

amount by which the Board could adjust the assessment rate schedule

without engaging in a notice-and-comment rulemaking proceeding. Such

adjustments would be applied to each cell in the rate schedule

uniformly; they could not be applied only to selected risk

classifications. For example, if the Board were to adjust the rate

schedule by a reduction of 2 basis points, then the assessment rate

applicable to each assessment risk classification would be reduced by 2

basis points (from, say, 4 to 2 basis points, 7 to 5 basis points, 14

to 12 basis points, and so on). Thus, the differences between the

respective cells in the rate schedule would remain unchanged.

Similarly, such adjustments would neither expand nor contract the 27-

basis point spread between the lowest- and highest-risk

classifications.

The 5 basis-point maximum would limit the extent to which the rate

schedule could be adjusted over time without triggering a new notice-

and-comment rulemaking proceeding. Thus, for example, if the rate for

1A banks were 4 basis points, no matter how many times the assessment

schedule were adjusted up or down, the rate for 1A banks could not be

increased over time to a rate higher than 9 basis points without a new

notice-and-comment rulemaking proceeding. The same limitations would

apply to rate reductions.

Under the proposal, the adjustment factor for any particular

semiannual period would be determined by (1) the amount of assessment

income necessary to maintain the reserve ratio at 1.25 percent (taking

into account operating expenses and expected losses and the statutory

mandate for the risk-based assessment system) and (2) the particular

risk-based assessment schedule that would generate that amount

considering the risk composition of the industry at the time. The Board

proposed to adjust the assessment rate schedule every six months by the

amount, up to and including the maximum aggregate adjustment factor of

5 basis points, necessary to maintain the reserve ratio at the DRR.

Such adjustments would be adopted in a Board resolution that reflects

consideration of the following statutory factors: (1) Expected

operating expenses; (2) projected losses; (3) the effect on BIF

members' earnings and capital; and (4) any other factors the Board

determined to be relevant.

The Board resolution would be adopted and announced at least 45

days prior to the date the invoice is provided for the first quarter of

the semiannual period for which the adjusted rate schedule would take

effect. Thus, the rate schedule applicable to the November 30 invoice

would be announced no later than October 16 and the schedule applicable

to the May 30 invoice would be announced by April 15. If the amount of

the adjustment under consideration by the FDIC would result in an

adjusted schedule exceeding the 5 basis-point maximum, then the Board

would initiate a notice-and-comment rulemaking proceeding to be

completed prior to the invoice date.

A total of 75 commenters addressed the issues of the proposed

process to adjust the rates and the amount of the adjustment factor. Of

the 61 comments in support of the process (including 8 trade

associations and 47 BIF members), 41 indicated that the size of the

adjustment factor (5 basis points) was appropriate. The ABA (as well as

the ABA State Association Division) supported the process only so long

as the purpose of the adjustment was to maintain the reserve ratio at

the DRR. A number of commenters, including Signet Banking Corporation

and Wells Fargo Bank, supported the proposed adjustment process but

noted that it should be used both for rate increases and decreases.

(The proposal intended that the adjustment process would be used both

for increases and decreases.) NationsBank also supported the proposal

but indicated any adjustments should be made not more frequently than

annually.

Other commenters expressed concern about the lack of opportunity

for comment, particularly where an increase in rates could have a

significant effect on BIF members. For example, the IBAA opposed the

use of the proposed adjustment process for increases but not for

decreases in the assessment schedule because of the lack of opportunity

to comment on assumptions made by the FDIC concerning expected

expenses, loss rates, investment income, and other factors. The IBAA

indicated that this is particularly important in a case where the FDIC

would raise the schedule by the full amount of the adjustment factor (5

basis points) which would represent more than double the proposed 4

basis-point rate for institutions in the 1A risk classification.

Chemical Bank opposed both the process and the size of the adjustment

factor for both increases and decreases in the rate, noting that an

increase of 5 basis points would represent more than a doubling of the

rate for most banks. The Bankers Roundtable also expressed concerns

with permitting the FDIC to raise assessments without notice and

comment where an increase could significantly increase costs to the

banks. To provide the FDIC with some flexibility, it proposed an

alternative process whereby the use of the adjustment factor at the

FDIC's sole discretion would be limited to 2 basis-point changes;

changes above 2 basis points but less than 5 basis points could be

imposed after an abbreviated comment period (two-three weeks); changes

above 5 basis points would go through the normal comment period.

Banc One Corporation opposed the proposed adjustment process based

on the erroneous belief that it would permit the Board to raise the

assessment schedule by as much as 9 basis points from one semiannual

period to another without the opportunity for notice and comment.

Instead, Banc One favored limiting the adjustment factor to an increase

or decrease of 1 basis point only. The New York Clearing House opposed

the adjustment process, noting that an increase of 5 basis points would

represent a 125 percent increase for banks with risk classification 1A.

However, the Clearing House also misunderstood the proposed process,

believing that the schedule could be increased sharply ``in only a few

years without ever seeking public comment''.

The Board has decided to adopt the proposed rate-adjustment

process, with two clarifications. First, given the apparent confusion

regarding the maximum extent to which the rate schedule could be

adjusted without triggering a new rulemaking proceeding,

Sec. 327.9(b)(1) of the final rule clarifies that the maximum

adjustment level of plus-or-minus 5 basis points is intended to apply

as an aggregate amount, over

[[Page 42740]]

time, taking into account both increases and decreases, but that no one

adjustment may constitute an increase or decrease of more than five

basis points. This clarification reflects the Board's intent to seek

public comment on, for example, a proposed increase of 3 basis points

for a semiannual period following an earlier period for which the

Board, by resolution, adjusted the rate schedule upward by 3 basis

points, or a proposed decrease of 6 basis points after a previous

increase of three basis points, but not to seek public comment on an

increase of 5 basis points following an intervening decrease of 2 basis

points.32 Similarly, language also has been added to this

paragraph to expressly state the Board's intent, as indicated in the

proposal, that any adjustment apply uniformly to each rate in the

schedule.

\32\ The following hypothetical examples illustrate this

concept. Example 1. (a) On April 15, 1996, the Board adjusts the

assessment rate schedule upward by 3 basis points to 7-to-34 basis

points. Notice-and-comment rulemaking is not required because the

increase does not exceed the 5 basis-point adjustment maximum. (b)

On October 16, 1996, the Board again increases the adjusted schedule

by 3 basis points, to 10-to-37 basis points. Such action requires

notice-and-comment rulemaking because it would result in an

aggregate increase of more than 5 basis points. Example 2. (a) On

April 15, 1996, the Board increases the rate schedule by 3 basis

points to 7-to-34 basis points. Notice and comment rulemaking is not

required. (b) On October 16, 1996, the Board decreases the

previously-adjusted schedule by 2 basis points to 5-to-32 basis

points. Rulemaking is not required because the change, in the

aggregate, does not result in an increase or decrease of more than 5

basis points. (The change, in the aggregate, is a net increase of

one basis point.) (3) On April 15, 1997, the Board adjusts rate

schedule upward by 5 basis points. Such action requires notice-and-

comment rulemaking because it would result in an aggregate increase

of more than 5 basis points, taking into consideration the previous

adjustments. In addition, notice-and-comment rulemaking would be

required for any single step in either of these examples which by

itself, without aggregation, would constitute an increase or

decrease of more than 5 basis points.

Second, the final rule also expressly reflects the FDIC's intent

promptly to make public the basis for any Board decision to adjust the

rate schedule. Under Sec. 327.9(b)(2) of the final rule, with this

clarification, the Board will announce the semiannual assessment

schedule for the next semiannual period, with the amount and basis for

any adjustment from the then-existing schedule, no later than 45 days

before the invoice date for the first quarter of that next semiannual

period (that is, by October 16 or April 15, as applicable).

The Board fully understands concerns regarding the possibility of

assessment rate increases without the benefit of full notice-and-

comment rulemaking. However, the Board notes that the adjustment

applies to decreases as well as to increases and that, in the current

economic environment, the former could be more common than the latter.

Moreover, the Board's discretion in applying the adjustment factor is

not unfettered. The maximum amount of the adjustments is limited to an

increase or decrease of 5 basis points, either at any one time or over

time, and in adopting an adjustment the Board must satisfy the criteria

enumerated in Sec. 327.9(b) of the final rule, which reflect the

statutory rate-setting factors referred to above. Moreover, as with any

of its decisions, the Board may act only after due deliberation and in

a reasonable manner. As previously indicated, the basis for any

adjustment adopted by the Board will be made public promptly after the

Board's decision.

Furthermore, while the Board appreciates these concerns, it also

recognizes that frequent rate adjustments may be necessary to maintain

the reserve ratio at the DRR, and is mindful of the costs involved--

both to the industry and the FDIC--of engaging in a formal rulemaking

proceeding each and every time even a minor adjustment in the

assessment rate schedule is needed. The Board believes--as do 61 of the

75 commenters addressing this issue--that an acceptable balance of the

competing concerns is achieved by the approach taken in the final rule.

The Board has noted the suggestion made by the Bankers Roundtable

that the final rule include a modified adjustment procedure under which

adjustments of between 2 and 5 basis points be subject to an

abbreviated notice-and-comment period of 2 to 3 weeks. However, the

Board is concerned that such a short period would not allow sufficient

time for interested parties both to become aware of a proposed

adjustment and still file timely comments. In addition, an abbreviated

comment period involves the same costs as a non-abbreviated period,

both to interested parties and to the FDIC.

The adjustment factor is expected to provide the Board with the

flexibility to raise a maximum additional $1.2-$1.4 billion in the near

term without undertaking an additional rulemaking. The 5 basis-point

maximum appears modest when viewed historically, as the loss-to-insured

deposits ratio has been quite variable; the standard deviation was 8.5

basis points for the 1934-94 period (Figure 8) and 11.9 basis points

for 1980-94. In view of the currently favorable banking environment,

however, a 5 basis-point adjustment factor should be sufficient to

maintain the target DRR in the near term.

VI. Technical Amendments

In addition to the amendments discussed above, the Board is further

amending the assessments regulation to delete the BIF Recapitalization

Schedule currently set forth in 12 CFR 327.9(d). Because the DRR has

already been or soon will be reached, this schedule is no longer

needed. Moreover, the schedule, which calls for BIF to reach the DRR in

2002, is now obsolete.

In addition, the final rule substitutes the term ``institution''

for the outdated term ``bank'' in Sec. 327.9(a).

VII. Paperwork Reduction Act

No collections of information pursuant to section 3504(h) of the

Paperwork Reduction Act (44 U.S.C. 3501 et seq.) are contained in this

notice. Consequently, no information has been submitted to the Office

of Management and Budget for review.

VIII. Regulatory Flexibility Act

The Regulatory Flexibility Act (5 U.S.C. 601 et seq.) does not

apply to a rule of particular applicability relating to rates, wages,

corporate or financial structures or reorganizations thereof. Id. at

601(2). Accordingly, the statute does not apply to the proposed changes

in the assessment rate schedule, the structure of that schedule and

future adjustments thereto. In any event, to the extent an

institution's assessment is based on the amount of its domestic

deposits, the primary purpose of the Regulatory Flexibility Act, that

agencies' rules do not impose disproportionate burdens on small

businesses, is fulfilled.

IX. Riegle Community Development and Regulatory Improvement Act of

1994

Section 302(b) of the Riegle Community Development and Regulatory

Improvement Act of 1994, Public Law 103-325, 108 Stat. 2160 (1994),

requires that, in general, new and amended regulations that impose

additional reporting, disclosure, or other new requirements on insured

depository institutions shall take effect on the first day of a

calendar quarter. This restriction is inapplicable to the final rule,

which does not impose such additional or new requirements.

List of Subjects in 12 CFR Part 327

Assessments, Bank deposit insurance, Banks, banking, Financing

Corporation, Savings associations.

For the reasons stated in the preamble, the Board is amending part

327 of title 12 of the Code of Federal Regulations as follows:

[[Page 42741]]

PART 327--ASSESSMENTS

l. The authority citation for part 327 continues to read as

follows:

Authority: 12 U.S.C. 1441, 1441b, 1817-1819.

2. Section 327.8 is amended by adding a new paragraph (i) to read

as follows:

Sec. 327.8 Definitions.

* * * * *

(i) As used in Sec. 327.9, the following terms have the following

meanings:

(1) Adjustment factor. The maximum number of basis points by which

the Board may increase or decrease Rate Schedule 2 set forth in

Sec. 327.9(a).

(2) Assessment schedule. The set of rates based on the assessment

risk classifications of Sec. 327.4(a) with a difference of 27 basis

points between the minimum rate which applies to institutions

classified as 1A and the maximum rate which applies to institutions

classified as 3C.

3. Section 327.9 is amended by revising paragraph (a), removing

paragraph (b), redesignating paragraph (c) as paragraph (d), and adding

new paragraphs (b) and (c) to read as follows:

Sec. 327.9 Assessment rate schedules.

(a) BIF members. Subject to Sec. 327.4(c), the annual assessment

rate for each BIF member other than an institution specified in

Sec. 327.31(a) shall be the rate in the following Rate Schedules

applicable to the assessment risk classification assigned by the

Corporation under Sec. 327.4(a) to that BIF member. Until the BIF

designated reserve ratio of 1.25 percent is achieved, the rates set

forth in Rate Schedule 1 shall apply. After the BIF designated reserve

ratio is achieved, the rates set forth in Rate Schedule 2 shall apply.

The schedules utilize the group and subgroup designations specified in

Sec. 327.4(a):

Rate Schedule 1

------------------------------------------------------------------------

Supervisory subgroup

Capital group --------------------------

A B C

------------------------------------------------------------------------

1............................................ 23 26 29

2............................................ 26 29 30

3............................................ 29 30 31

------------------------------------------------------------------------

Rate Schedule 2

----------------------------------------------------------------

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