Doing the Market’s Dirty Work: FDIC Bank Closures

Feb 7, 2010

posted by Oliver Wright Esq.

When financially frail firms can’t pay creditors, they fail. The market drives the process like this: First, the firm starts losing. Second, creditors discover the losses and increase their estimate of the firm’s probability of default. Third, to reward themselves for this increased risk, creditors demand higher interest rates or require debt repayment.Fourth, when the firm can’t raise additional funds to meet those demands, it defaults.

Fifth, creditors force the firm into bankruptcy or the firm privately arranges with creditors for a payout of firm assets. In either case, the assets can be redeployed to more valuable uses, thus benefiting society in that business resources are not devoted to ineffectual enterprises. But what about banks? Deposit insurance short-circuits the market’s discipline of banks, thus muting the societal benefits that naturally accrue via the above process. Because market forces are unlikely to bring about the timely closure of troubled banks, the government agencies that charter and supervise banks are typically left to decide when a bank is no longer viable and should be closed. Mistakes by the agencies can create significant inefficiencies.

For example, during the 1980s many insured depository institutions remained open long after they became insolvent. As a result, financial resources were tied up in inefficient operations for extended periods. Legislators recognized the problem and in 1991 enacted the Federal Deposit Insurance Corporation Improvement Act (FDICIA). The Act required bank supervisors to step in and close depository institutions more quickly and reformed the process by which the Federal Deposit Insurance Corporation disposed of failed depositories. All of which raise the crucial question: How do these agencies decide when to step in under rules established by the FDICIA? Further, how do the agencies proceed following intervention?

The following article answers these questions….

From: Closing troubled banks: how the process works. by Walter, John R.
Source: Economic Quarterly, 1/1/2004.
Via: HighBeam™ Research
COPYRIGHT 2004 Federal Reserve Bank of Richmond