The Fair Value of the Federal Deposit Insurance Guarantee: Working Paper 2007-13

Working Paper
November 1, 2007

Judy Ruud

The Federal Deposit Insurance Corporation (FDIC), an agency of the U.S. government, guarantees insured deposits in banks and savings associations in the event of the depository’s insolvency. When a bank fails, the shortfall between the value of the bank’s available assets and the value of its insured deposits is a cost to the deposit insurer and hence the government. As of December 2006, the FDIC insured an estimated $4.1 trillion in deposits.

Deposit insurance is accounted for in the federal budget on a cash basis. This means that the cost of deposit insurance is recognized when cash is paid out by the government offset by collections from insurance premiums and recoveries in the same budget period. Budget projections thus require estimates of expected future claims on the FDIC from bank failures. Those estimates are prepared largely using linear extrapolations of current claims toward a long-term historical average. This paper describes a model for making those estimates in a more systematic way, taking account of banks’ capital position and volatility in the value of their assets—two primary drivers of bank failure.

The model projects the year-by-year probability distribution of the number of bank failures, and the assets and insured liabilities of the failing banks. Drawing on an extensive academic literature and standard market usage, an options-pricing model is used to estimate the present-value cost to the taxpayer of those failures, assuming discount rates that reflect the correlation of defaults with market conditions that the private market would use to value similar liabilities (that is, “fair value”). The fair value of the deposit insurance guarantee for each bank is the estimated price that private insurers would charge to a ssume the FDIC’s deposit insurance guarantee obligation.

The likelihood of failure—and the option value of the deposit insurance guarantee—is sensitive to several key variables: the initial level of bank capital, bank asset volatility, and the term of the insurance. The greater the initial level of capital, the lower the likelihood of failure. The longer the term of the insurance and the greater the volatility of bank asset values, the greater the likelihood of failure and the value of the deposit insurance guarantee.

Calculations were made using 2004 data for a set of 231 exchange-traded banks and bank holding companies, constituting about 30 percent of the deposits of FDIC-insured institutions. The model projects FDIC cash outlays of about $875 million (undiscounted) over the next 5 years. That estimate is net of the FDIC’s recoveries from the assets of failed banks but excludes collections of deposit insurance premiums. Using private-sector discount rates, the fair value of the deposit insurance (again excluding premiums) over 5 years is about $1.2 billion. Extrapolating to all FDIC-insured institutions, the 5-year fair value of deposit insurance is about $4 billion.

The total cost of providing deposit insurance includes, in addition to the cost of the guarantee, the administrative cost of monitoring the banks. Higher monitoring costs tend to reduce guarantee costs. That is, the more closely banks are monitored for safety and soundness, the greater the monitoring cost, and the smaller the guarantee cost because the guarantee agency is better able to prevent losses from accumulating at an insured bank (for example, by closing it). If a bank’s position could be monitored accurately and continuously, the guarantee cost would approach zero, because the bank could be closed when it became insolvent. In fact, however, an insurer’s ability to monitor a depository is limited and periodic, so that guarantee costs are usually positive. However, in periods when few banks fail, the monitoring cost of deposit insurance can be greater than the guarantee cost.

The FDIC spends about $1 billion annually on operating expenses and about half of that amount is identified as the cost of supervision. On the grounds that all of the FDIC’s expenses are related to the insurance function, in this paper all administrative costs are categorized as monitoring costs. The source of most of the financing for the FDIC’s expenses is intragovernmental interest credited to the deposit insurance fund overseen by the FDIC. Three other federal regulators also monitor FDIC-insured depositories: the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), and the Federal Reserve. The OCC and the OTS charge banks for their examinations; the Federal Reserve does not charge for its monitoring and it is difficult to identify its FDIC-related cost.