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How Incentive-Incompatible Deposit-Insurance Funds Fail

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  • Edward J. Kane

Abstract

An incentive-incompatible deposit-insurance fund (IIDIF) is a scheme. Lot guaranteeing deposits at client institutions that deploys defective systems of information collection, client monitoring, and risk management. These defective systems encourage voluntary risk- taking by clients and by managers and politicians responsible for administering the fund. The paper focuses on how principal-agent conflicts and asymmetries in the distribution of information lead to myopic behavior by IIDIF managers and by politicians who appoint and constrain them. Drawing on data developed in legislative hearings and investigations and in sworn depositions, the paper documents that managers of IISIFs in Ohio and Maryland knew well in advance of their funds' 1985 failures that important clients were both economically insolvent and engaging in inappropriate forms of risk-taking. It also establishes that staff proposals for publicizing and bringing these clients' risk-taking under administrative control were repeatedly rejected. The analysis has a forward-looking purpose. Congress and federal regulators have managed the massively undercapitalized Federal Savings and Loan Insurance Corporation (FSLIC) in much the same way Ohio and Maryland officials did. Unless and until incentives supporting political, bureaucratic and private risk-taking are reformed, the possibility of a FSLIC meltdown cannot be dismissed. To encourage timely intervention into insolvencies developing in a deposit-insurance fund's client base, the most meaningful reforms would be to force the development and release of estimates of the market value of the insurance enterprise and to require fund managers to use the threat of takeover to force decapitalized clients to recapitalize well before they approach insolvency.

Suggested Citation

  • Edward J. Kane, 1989. "How Incentive-Incompatible Deposit-Insurance Funds Fail," NBER Working Papers 2836, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:2836
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    References listed on IDEAS

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    1. Edward J. Kane, 1987. "Who Should Learn What From the Failure and Delayed Bailout of the ODGF?," NBER Working Papers 2260, National Bureau of Economic Research, Inc.
    2. Edward J. Kane, 1985. "The Gathering Crisis in Federal Deposit Insurance," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262611856, December.
    3. Edward J. Kane, 1987. "DANGERS OF CAPITAL FORBEARANCE: THE CASE OF THE FSLIC AND “ZOMBIE” S&Ls," Contemporary Economic Policy, Western Economic Association International, vol. 5(1), pages 77-83, January.
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    Cited by:

    1. William P. Osterberg & James B. Thomson, 1990. "The effect of subordinated debt and surety bonds on banks' cost of capital and on the value of federal deposit insurance," Working Papers (Old Series) 9012, Federal Reserve Bank of Cleveland.
    2. Charles W. Calomiris, 1994. "Is the discount window necessary? a Penn Central perspective," Review, Federal Reserve Bank of St. Louis, issue May, pages 31-55.
    3. Ross Levine & Norman Loayza & Thorsten Beck, 2002. "Financial Intermediation and Growth: Causality and Causes," Central Banking, Analysis, and Economic Policies Book Series, in: Leonardo Hernández & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.),Banking, Financial Integration, and International Crises, edition 1, volume 3, chapter 2, pages 031-084, Central Bank of Chile.
    4. Michael Gavin & Ricardo Hausmann, 1996. "Las raíces de las crisis bancarias: contexto macroeconómico," Research Department Publications 4027, Inter-American Development Bank, Research Department.
    5. James B. Thomson & Walker F. Todd, 1990. "An insider's view of the political economy of the too big to fail doctrine," Working Papers (Old Series) 9017, Federal Reserve Bank of Cleveland.
    6. Michael Gavin & Ricardo Hausmann, 1996. "The Roots of Banking Crises: The Macroeconomic Context," Research Department Publications 4026, Inter-American Development Bank, Research Department.
    7. Brock, Philip L., 1998. "Financial safety nets and incentive structures in Latin America," Policy Research Working Paper Series 1993, The World Bank.
    8. Bruno Meyerhof Salama & Vicente P. Braga, 2023. "The case for private administration of deposit guarantee schemes," Journal of Banking Regulation, Palgrave Macmillan, vol. 24(1), pages 51-65, March.
    9. Frederic S. Mishkin, 1992. "An Evaluation of the Treasury Plan for Banking Reform," Journal of Economic Perspectives, American Economic Association, vol. 6(1), pages 133-153, Winter.
    10. Guillaume Arnould & Giuseppe Avignone & Cosimo Pancaro & Dawid Żochowski, 2022. "Bank funding costs and solvency," The European Journal of Finance, Taylor & Francis Journals, vol. 28(10), pages 931-963, July.
    11. Alan D. Morrison & Lucy White, 2005. "Crises and Capital Requirements in Banking," American Economic Review, American Economic Association, vol. 95(5), pages 1548-1572, December.
    12. Delis, Manthos D. & Iosifidi, Maria & Papadopoulos, Panagiotis, 2022. "Blessing or curse? Government funding of deposit insurance and corporate lending," Journal of Financial Stability, Elsevier, vol. 61(C).
    13. Morrison, Alan D. & White, Lucy, 2010. "Reputational contagion and optimal regulatory forbearance," Working Paper Series 1196, European Central Bank.
    14. Gluzmann, Pablo & Guzman, Martin, 2017. "Assessing the robustness of the relationship between financial reforms and banking crises," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 49(C), pages 32-47.
    15. George G. Kaufman, 2003. "Depositor liquidity and loss-sharing in bank failure resolutions," Working Paper Series WP-03-02, Federal Reserve Bank of Chicago.
    16. Morrison, Alan D. & White, Lucy, 2011. "Deposit insurance and subsidized recapitalizations," Journal of Banking & Finance, Elsevier, vol. 35(12), pages 3400-3416.
    17. Ho, Chia-Ling & Lai, Gene C. & Lee, Jin-Ping, 2014. "Financial reform and the adequacy of deposit insurance fund: Lessons from Taiwanese experience," International Review of Economics & Finance, Elsevier, vol. 30(C), pages 57-77.

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