Federal Reserve Bank of San Francisco

FRBSF Economic Letter

1997-31 | October 24, 1997

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Federal Subsidies in Banking: The Link to Financial Modernization

Fred Furlong

Western Banking Quarterly is a review of banking developments in the Twelfth Federal Reserve District, and includes FRBSF’s Regional Banking Tables. It is published in the Economic Letter on the fourth Friday of January, April, July, and October.

Concern over extending the federal safety net is a perennial issue in legislative measures to allow greater integration of banking and other financial services. And, it remains central to the testimony on financial modernization in the current session of Congress. At issue is whether the safety net results in subsidies to banks and the implications that might have for expanding the scope of their activities.

The safety net

A bank charter entails access to a set of services that make up the federal safety net. The most broadly used service is federal deposit insurance, administered by the Federal Deposit Insurance Corporation (FDIC). Other key services are provided by the Federal Reserve and include discount window lending, along with daylight overdrafts and finality in settlements in the payment system. The policy rationale for having the safety net is that it provides public benefits, like greater financial stability, which outweigh the associated costs.

The common feature of these services is their tie to bank funding. Deposit insurance allows banks to issue federally guaranteed debt. From the discount window, banks borrow directly from the Federal Reserve. Daylight overdrafts are intra-day loans made by the Federal Reserve to facilitate the clearing of payments. In making these loans, the Federal Reserve guarantees “good funds” for the institutions credited in the clearing of payments.

Is there a subsidy?

The safety net, then, involves access to federally guaranteed funds and direct federal lending. The potential for a gross subsidy arises when a bank’s cost of obtaining funds from a safety net component is lower than the appropriate market rate. For an individual bank, its “market rate” would reflect the level of open market rates and institution-specific factors, including its risk. At the same time, a bank may incur other costs associated with tapping the safety net or having a bank charter that could result in a smaller or even zero net subsidy.

Because a bank’s cost of obtaining funds from the safety net does not fully reflect its risk, the gross subsidy increases with the riskiness of a bank, creating incentives for risk-taking. It is not that a bank deliberately would try to exploit the safety net; it is just that, with the reassurance of the safety net, private sector holders of bank debt are willing to accept a bank’s operating with less capital and a riskier portfolio than they would otherwise. This moral hazard problem is a key rationale for prudential regulation and close supervision of commercial banks.

The most likely candidates for the deposit insurance subsidy are insured retail deposits– that is, deposit accounts under $100,000. Evidence in Levonian and Furlong (1995) suggests that the deposit insurance subsidy was particularly high in the early 1990s, a time of widespread losses and marked deterioration in capital among banks. However, with strong financial conditions in banking today, the exposure of the deposit insurance system and, thus, the deposit insurance subsidy, have declined substantially.

In addition to retail deposits, other bank debt may be partially protected as a result of implicit federal insurance. Until the 1990s, for example, holders of uninsured bank liabilities generally were made whole as a result of the resolution procedures used by the FDIC in handling troubled banks. However, changes in regulatory policies in the 1990s, which include those flowing from the Federal Deposit Insurance Corporation Improvement Act (FDICIA)–depositor preference, prompt corrective action, low-cost FDIC closure policies, and strict limits on the bailout of large institutions–likely have helped reduce the exposure of the FDIC.

For other parts of the safety net, borrowing from the discount window is collateralized, though the discount rate generally is below the overnight federal funds rate. Under normal market conditions, this subsidy is not a major issue since discount window loans are a very small fraction of bank funding. The potentially more important issue is the value to a bank of having the discount window as a backup line of credit, though even the value of this option may have been reduced by restrictions on Federal Reserve lending to financially troubled institutions.

In the payments system, it is clear that prior to the pricing of daylight overdrafts, banks received subsidized credit since, subsequent to explicit pricing, the volume of intra-day loans dropped noticeably. However, the intra-day rate probably still does not represent full market pricing, so some gross subsidy likely remains.

Are there offsetting costs?

Yes–banks clearly incur costs that offset the gross subsidy. In fact, it must be true that the value of the subsidy is offset at the margin. Otherwise the competitive advantage afforded banks would lead them to gain an ever-increasing share of total financial assets, which is not happening.

Among the costs that could work to offset subsidies on the margin are deposit insurance premiums since they can vary some with risk. However, currently the premiums for the vast majority of banks are virtually zero. On the other hand, the current risk-focused approach of bank regulators likely means that regulatory costs are higher for riskier banks and serve as offsets. Diseconomies of scale in banking also could raise costs and limit a bank’s expansion.

Banks also incur other regulatory costs that do not necessarily vary with risk, but still work to offset the average deposit value of the federal subsidy. Commercial banks, for example, were assessed a high average deposit insurance premium for a period of time to replenish the reserves of the FDIC. Banks also maintain required reserves that do not earn interest at Federal Reserve Banks. It is difficult to say to what extent these types of costs to banks offset the gains from having access to the safety net. However, it is probably not the case that the costs more than offset the average value of the subsidies. If this were true for any length of time for banks, they would be looking regularly to shed their charters, unless the charters entail additional value, perhaps owing to some market power, beyond the subsidies from the safety net.

Issues for financial modernization

The presence of gross subsidies from the federal safety net calls for caution in approaching financial modernization. This is true even though there is good reason to believe that the subsidies are currently offset, at least on the margin. The concern is that expanding activities for banking organizations would extend the safety net and add to the gross subsidy. Other costs, including those from expanded supervision and regulation, would be expected to rise and offset the subsidy. However, without a public benefit from extending the safety net beyond banks, those added costs would be dead-weight losses that should be avoided.

Apparently with the intent to do just that, the current legislative proposal for financial modernization would maintain the legal separation between banks and the rest of an integrated financial organization. The legislative proposals being considered by the House, for example, would not allow banks to engage directly in most securities activities and insurance underwriting. Such activities would have to be carried out through separately capitalized bank subsidiaries or holding company affiliates. The legal separation between banks and nonbank entities is intended to keep the federal safety net targeted only at insured depository institutions and depository institutions with direct access to the discount window and the payments system.

Frederick Furlong
Vice President


Levonian, M., and F. Furlong. 1995. “Reduced Deposit Insurance Risk.” FRBSF Weekly Letter 95-08.

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