Summary of FDIC s Restoration Plan & Proposal to Change the Risk-Based Assessment Calculation

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1 Summary of FDIC s Restoration Plan & Proposal to Change the Risk-Based Assessment Calculation On Wednesday, October 7, 2008, the FDIC Board released a 5-year recapitalization plan and a proposal to raise premiums to accomplish this goal. Even with this aggressive plan, the FDIC projects that the reserve ratio will continue to fall for the remainder of this year and early 2009 to a low of 0.65 to 0.70 percent, as the fund s loss reserves for anticipated failures increase. Higher assessment revenue should begin to increase the reserve ratio gradually in the latter part of 2009, rising to 1.25 percent by The FDIC is seeking public comment on the proposal and will accept comments for a 30-day period. ABA will be commenting and we would like banker feedback on this proposal. Premium Rates Double FDIC proposes to increase by 7 basis points (bp) the entire premium schedule for the first quarter of This means that the premium for well-capitalized and CAMELS 1 and 2 rated banks (Category I) will be between 12 and 14 bp (from the current 5 to 7 bp). After the first quarter, the FDIC proposes to adjust the risk-based premium calculation to include new risk factors, and the rate for Category I banks will be between the base rate of 10 bp and the ceiling of 14 bp. Adjustments to the calculation, however, can lower premiums below the base rates and raise premiums above the ceiling rate. The table on the next page shows the premium rates and the distribution of institutions likely to be in each. ABA estimated a month ago that with losses of $6 billion per year for 5 years and insured deposit growth of 4 percent per year, the required premium would average 9 basis points (or a range of 8 to 12 bp). The differences in what we estimated and the FDIC s proposed rates are a result of two things: The FDIC expects that the income resulting from its schedule (with the base rate of 10 bp) will return the reserve ratio of the fund to 1.26 percent in 5 years. Had the FDIC used a base rate of 9 bp, the reserve ratio would be above 1.15 percent within the 5-year period. The FDIC stated that it was prudent to provide this margin for error in the event that losses exceed staff s best estimate or insured deposit growth is more rapid than expected. The FDIC assumes insured deposits will grow by 5 percent (which is the average growth rate over the last 5 to 10 years) over the next 5 years. Had a more reasonable growth rate been used such as 3 percent, reflective of an economy near recession 1 The FDIC stated that the reason for the first quarter assessment under the old system was that there was not enough time to fully implement the revised risk-based system in time for the first quarter assessment.

2 and slow income growth the base rate would have been 8 bp, rather than 10 bp, as proposed. It is instructive to note that in the early 1990s, insured deposit growth was negative. The FDIC s analysis does not factor in the benefits that may result from the passage of the Emergency Economic Stabilization Act. Distribution of Total Base Assessment Rates and Domestic Deposits* Data as of June 30, 2008 Risk Category I II III IV Total Base Assessment Rate Number of Institutions Percent of Institutions Domestic Deposits ($ in Billions) Percent of Domestic Deposits ,834 22% $ % ,674 32% $ 3, % ,588 31% $ 1, % % $ % % $ % % $ % % $ 8.0 0% % $ % % $ 5.8 0% % $ % *Because of data limitations, secured liability adjustments for TFR filers are calculated using imputed values based on simple averages of Call Report filers as of June 30, Unsecured debt adjustments are calculated using "Qualifying subordinated debt and redeemable preferred stock" included in Tier 2 capital. New Factors Proposed to Calculate Premiums Not only will premiums increase, but the factors used to calculate the premiums will change. These include (1) excessive use of brokered deposits tied to rapid growth; (2) excessive use of secured liabilities; and (3) lower assessments (even below the 10 bp base rate) for very high levels of capital for small institutions. For large banks (i.e., greater than $10 billion in assets), the premium calculation is also changed by adding financial ratios to CAMELS and debt issuer ratings (each counting for one-third) and providing a reduction for unsecured debt on the books. The FDIC has stated that all these changes add significantly to premium income, allowing a reduction in premiums for banks with lower risk profiles. The FDIC comments that this effectively transfers the higher premiums to institutions that are most likely to cause loss to the Deposit Insurance Fund.

3 Brokered Deposits Included as Another Risk Factor The FDIC is proposing to add use of brokered deposits in combination with rapid growth as a factor with other financial ratios. The adjusted brokered deposit ratio would only affect those institutions whose total assets were more than 20 percent greater than they were four years earlier after adjusting for mergers and acquisitions and whose brokered deposits made up more than 10 percent of domestic deposits. 2 For Category I banks that exceed the thresholds above, a new ratio is added to the other financial ratios in calculating the premium. 3 For banks in Risk Categories II, III, and IV, there is an additional brokered deposit adjustment. The added premium is calculated by taking the ratio of brokered deposits to domestic deposits less 10 percent multiplied by 25 basis points. The maximum brokered deposit adjustment will be 10 basis points. The FDIC uses Call Report information on brokered deposits variable and other financial ratios. Currently, there is no distinction between various types of brokered deposits, such as reciprocal deposits (e.g., CDARS) and sweeps from broker/dealer affiliates to their banks. The FDIC asks whether sweep accounts that currently meet the brokered deposit definition should be excluded; whether reciprocal deposits should be excluded; and whether high cost deposits (such as from listing services) should be included. ABA has already written Chairman Bair about distinguishing between these types, arguing that the use of reciprocal deposits and sweeps from broker/dealer affiliates have characteristics more typical of core deposits. Secured Liabilities The FDIC proposes an add-on charge to the assessment rate for an institution if the ratio of secured liabilities including Federal Home Loan Bank advances to domestic deposits exceeds 15 percent of domestic deposits. Secured liabilities include securities sold under repurchase agreements, secured federal funds, Federal Home Loan Bank advances, and any other secured borrowings. The calculation is made by multiplying the base assessment rate by one plus the ratio of the bank s secured liabilities to domestic deposits minus This 2 The theory is that over-reliance on using brokered deposits can cause a liquidity crisis at the very time the institution needs funding the most. This is particularly the case with brokered deposits where the FDIC must approve any use for adequately-capitalized institutions and where under-capitalized institutions are prohibited from using such deposits. Moreover, FDIC argues that the franchise value of a troubled institution may decrease the greater the reliance on noncore deposit funding, thus making it more difficult for a troubled bank to merge with a healthier bank (or be sold by the FDIC in its role as conservator as in the case of IndyMac). 3 This adjusted factor is calculated as follows: Calculate the excess portion of brokered deposits beyond the 10 percent threshold. Then calculate the asset growth factor by taking the actual growth rate (from 4-years prior until the present quarter) less 0.20 (the 20 percent growth threshold) multiplied by five. Then multiply the asset and brokered deposit ratios together to give the adjusted deposit ratio. Finally, this adjusted ratio is multiplied by to give a new ratio which is considered as part of the other financial ratios in determining the premium rate. If the asset growth factor is greater than 40 percent, the weighting for this factor is 100 percent.

4 additive factor may increase the assessment of Category I banks above the ceiling rate of 14 bp (and cannot add more than 50 percent to the initial assessment rate). The FDIC advanced three theories for why secured deposits should be included: first, the fact that the Home Loan Bank can refuse to lend, and often does so, to an institution with declining financial ratios, thus creating a liquidity problem for the bank. Second, that the loss-given failure is higher in cases with advances because, as secured liabilities, they stand ahead of FDIC (as a general creditor in place of insured depositor claims) in a receivership. The secured nature of advances leaves fewer, high-quality, assets able to cover expected losses, leaving the FDIC with higher costs. Third, that there is a pricing disparity between those banks with primarily deposit funding versus those with a high percentage of advances. This, FDIC argues, is a result of the assessment base being only total domestic deposits. Thus, a $100 million bank with 100 percent deposit funding will pay twice as much to the FDIC as an identical bank (size and risk) with 50 percent deposit funding and 50 FHLB advances. Put another way, the deposit funded bank, FDIC argues, will pay more to cover losses incurred by FDIC than those with high concentrations of advances. ABA has long opposed including Federal Home Loan Bank advances in the risk-based formula, and industry opposition helped to keep such a factor out of the original risk-based calculation. ABA s FHLB Committee met by conference call last week with FDIC staff and expressed concern with the general outlines of the approach put forward. Many banks believe that funding from advances provides added liquidity (thereby reducing the risk of a failure), allows match funding (of both securities and loans to lock in a return), and provides a lower cost funding option in areas where local interest rates are high. Bankers have also argued that the risk is not in the funding source, but in the assets that the funds are invested in. FDIC to Give Credit to Banks with Very High Capital Levels The FDIC is proposing to give banks a discount on premiums for high levels of qualifying Tier 1 capital. This discount can even lower a bank s assessment below the base rate of 10 bp. 4 Any decrease in base assessment rates would be limited to two basis points. Changes to the Large Bank Pricing Model The FDIC proposes to add financial ratios to the large bank pricing model and to provide a reduction in rates for unsecured debt of the bank (which would reduce the loss to the FDIC in the event of failure). Under the current formula, large bank premiums are determined by a combination of CAMELS ratings and debt-issuer ratings. The FDIC believes that the debt- 4 The amount of qualified Tier 1 capital would be the sum of one-half of the Tier 1 capital amount between 10 percent and 15 percent of adjusted average assets (for Call Report filers) or adjusted total assets (for TFR filers) and the full amount of Tier 1 capital amount exceeding 15 percent of adjusted average assets (for Call Report filers) or adjusted total assets (for TFR filers).

5 issuer ratings have not been responsive to market changes and, therefore, the premium rate calculated by the current formula is under-pricing the true risk. Moreover, the FDIC is required under law not to create disparities between banks of different sizes and the FDIC has observed that the percentage of small banks paying the lowest (base) premium rate is declining much faster than large banks. The FDIC proposes to include financial ratios with CAMELS ratings and debt issuer rates, with each component accounting for one-third of the premium rate. The actual weighting would be calibrated to keep the distribution of large and small banks across the risk-rate structure similar. The FDIC recognizes that long-term unsecured debt (with maturities greater than 1 year) covers losses dollar for dollar before FDIC takes losses in the event of a failure. This factor would reduce the premium assessment up to two basis points. Comptroller Dugan noted at the Board meeting that the reduction in premiums for unsecured debt is far less than the penalty for secured borrowing. He questioned the rationale for this decision. Premium Increase Effective First Quarter 2009 After reviewing the public comments, the FDIC Board must approve any final change to the assessment schedule and provide notice to the industry. Given the 30-day comment period, the FDIC is likely to make a final decision regarding the first quarter assessment by the end of this year. This would be billed on June 15, 2009, payable June 30, The FDIC may take more time to consider changes to the risk-based system, but it would make a final decision with notice to the industry before the second quarter. Assessment credits will largely be exhausted by year-end FDIC to Revisit Premium Rates at Least Annually The FDIC would continue to have the flexibility to update the pricing multipliers and the uniform amount annually, without further notice-and-comment rulemaking. The FDIC proposes having authority to adjust the entire rate schedule by 3 bp without notice and comment. ABA has urged the FDIC to lower premiums rapidly if the recapitalization is occurring faster than the FDIC anticipated. This would allow the FDIC to utilize the full 5- year recapitalization period and not impose an excessive cost on banks just to raise the reserve ratio to the required level faster than is necessary under law. FDIC Can Make a One-Basis-Point Adjustment Upon Further Review Under current rules, the FDIC has authority each quarter to consider additional factors and raise or lower premiums by a half a basis point. Because the range from the base to the ceiling rates for most banks is now 4 basis points, the FDIC is proposing to increase the authority to adjust rates up or down by as much as one basis point. ABA has urged the FDIC to consider such an adjustment factor for banks with exposure to Freddie Mac and Fannie Mae preferred securities or asset backed securities based on these.