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The National Depositor Preference Law


									                                                                                                                     February 15, 1994

                                                     Federal Reserve Bank of Cleveland

The National Depositor Preference Law
by James B. Thomson

-Liast August 10, Congress passed the           • The Legislative Provisions
Omnibus Budget Reconciliation Act of            Title III of OBRA93 instituted depositor
                                                preference for all insured depository insti-   The national depositor preference
 1993 (OBRA93). Contained in this legis-
                                                tutions by amending Section 1 l(d)(l 1) of     law was added to the 1993 budget act
lation was a provision that dramatically
                                                the Federal Deposit Insurance Corpora-         to reduce the government's cost of
revised the priority of claims on failed de-
                                                tion Act.2 The amendment establishes           providing deposit insurance. A care-
pository institutions. The Act's effect was
                                                the following priority of payment in re-       ful look at depositor preference and
to give depositors (and, by implication,
                                                solving failed depositories:                   its attendant effects suggests that it
the Federal Deposit Insurance Corporation
                                                                                               will provide only minor cost savings.
[FDIC]) a superior, or preferred, claim on
                                                                                               In fact, in some cases it could increase
a failed bank's assets relative to that of      1. Administrative expenses of the
                                                   receiver                                    the Federal Deposit Insurance Corpo-
other general creditors. By doing so, Con-
                                                                                               ration's losses from bank failures.
gress hoped to reduce the FDIC's losses         2.   Deposit liabilities
from bank failures. In fact, the Office of      3.   General or senior liabilities
Management and Budget estimated that a
                                                4.   Subordinated obligations
national depositor preference law could cut
                                                5.   Shareholder claims
the FDIC's expected losses by $1 billion
over the next five years.
                                               Prior to passage, general or other senior
                                               liabilities had the same priority of pay-
Being buried in a much larger piece of         ment as deposits. As before, secured
legislation, depositor preference received     creditors of the failed institution will
little public attention and was passed with    have their claims satisfied first, up to the
almost no debate. This is unfortunate, be-     amount of the collateral. This is an impor-
cause economic policies often have unin-       tant detail, since one avenue for general
tended, secondary effects that dominate        or senior creditors to pursue in reaction to
the intended ones. In the case of deposi-      depositor preference laws is to take collat-
tor preference laws, the general creditors     eral to protect their claim.
of banking firms are likely to take action
to protect their claims. As a consequence,
                                               On August 13, 1993, the FDIC issued
the loss exposure of the FDIC could actu-
                                               an interim rule interpreting the deposi-
ally increase.
                                               tor preference amendment.3 The im-
                                               portance of this rule is that it clarifies
In this article, we take a critical look at    what the FDIC will consider as admin-
depositor preference. The first section        istrative expenses of the receiver. Un-
outlines the new legislation and the           der the FDIC's interpretation, these in-
FDIC's implementation of it, and the           clude "post-appointment obligations
second examines the way in which de-           incurred by the receiver as part of the
positor preference restructures a bank's       liquidation of an institution ... and cer-
liabilities. We then examine the possi-        tain expenses incurred prior to the ap-
ble reactions of nondeposit creditors to       pointment of the receiver."4 In other
this restructuring and discuss the impli-      words, the receiver (which for most
cations for policy.                            banks and thrifts is the FDIC) may pay
                                               expenses it deems consistent with the
                                               orderly closure of the institution, even
                   A SIMPLE BANK BALANCE SHEET                                                   claims equal $12 million, distributed as
                                                                                                 follows: insured deposits (FDIC) = $8
               Assets                         Liabilities with No Depositor Preference           million, uninsured deposits = $3 mil-
                                                                                                 lion, and general creditor claims = $1
Collateral (CA)                       Collateralized claims (CC)
                                                                                                 million.8 The proportion of senior claims
General assets (GA)                   Senior claims (SC)
                                                                                                 by type are WFDIC = 0.6667 (8/12), WUD
                                        Insured deposits (FDIC)
                                        Uninsured deposits (UD)                                  = 0.25, and WGCC = 0.0833. Since senior
                                        General creditor claims (GCC)                            claims exceed the general asset pool by
                                      Subordinated debt claims (SDB)                             $2 million, senior creditors are not repaid
                                      Equity (E)                                                 in full: Each loses $0.17 per dollar of
                                                                                                 claim. Without depositor preference, total
                                               Liabilities with Depositor Preference
                                                                                                 payments to senior creditors are $6,667
                                      Collateralized claims (CC)                                 million to the FDIC, $2,500 million to un-
                                      Deposit claims (SDC)                                       insured depositors, and $0,833 million to
                                        Insured deposits (FDIC)                                  general creditors (see table 1).
                                        Uninsured deposits (UD)
                                      Other senior claims (OSC)
                                        General creditor claims (GCC)                            Under depositor preference, general
                                      Subordinated debt claims (SDB)                             creditor claims would be paid after
                                      Equity (E)                                                 those of both the uninsured depositors
                                                                                                 and the FDIC (see box). Therefore, af-
                                                                                                 ter netting out the collateralized claims,
                                                                                                 the available general asset pool is used
if those expenses were incurred prior to           Liabilities are listed in order of priority
                                                                                                 first to satisfy the claims of depositors,
closure. These pre-receivership costs              of payment.
                                                                                                 with any remaining funds going to sat-
include payment of the institution's last
                                                                                                 isfy the claims of the other senior credi-
payroll, guard services, data processing           When a depository enters receivership,
                                                                                                 tors and then the subordinated debt-
services, utilities, and leases. Examples          secured creditors take possession of the
                                                                                                 holders. Using numbers from the above
of expenses that would be excluded                 specific collateral securing their claim.
                                                                                                 example, we can see the intended effect
from administrative expenses are items             For simplicity, we assume that collat-
                                                                                                 of depositor preference. Depositors'
such as golden parachute claims, sever-            eral equals collateralized claims (CA =
                                                                                                 claims (the FDIC and uninsured deposi-
ance pay claims, and liabilities arising           CC), so that the value of the collateral
                                                                                                 tors) equal $ 11 million. By giving each
from the repudiation of contracts.                 exactly exhausts the claims of the se-
                                                                                                 a higher priority of payment in receiver-
                                                   cured creditors.7 Without depositor
                                                                                                 ship, general creditor claims now pro-
One issue not addressed by the interim             preference, the general asset pool (GA)
                                                                                                 vide them with a loss buffer. Since gen-
rule is the status of deposits in foreign          is used first to pay the claims of senior
                                                                                                 eral assets equal $10 million, the FDIC
branches of insured depositories. Such             creditors. If this amount is less than the
                                                                                                 and uninsured depositors will exhaust
deposits are excluded from the assess-             general asset pool, then the residual
                                                                                                 the asset pool. Losses per dollar of de-
ment base of the FDIC and thus, for pur-           funds (GA - SC) are used to meet the
                                                                                                 posit are $0.09, 45 percent less than
poses of deposit insurance, are different          claims of the junior (subordinated)
                                                                                                 without depositor preference. For com-
from domestic deposit claims. Conse-               creditors, with any remainder accruing
                                                                                                 parison purposes, payments are $7,273
quently, a reasonable interpretation of the        to equityholders. If, however, senior
                                                                                                 million to the FDIC, $2,727 million to
depositor preference statute is that for-          creditor claims exceed the value of the
                                                                                                 uninsured depositors, and $0 to general
eign depositors are considered general             institution's assets, then each senior
                                                                                                 creditors. Depositor preference reduces
creditors.5 It is possible that the FDIC's         claimant will share in the shortfall in
                                                                                                 the losses of the FDIC and uninsured
final ruling will reflect this view.               proportion to his claim. That is, each
                                                                                                 depositors by redistributing wealth to
                                                   will receive W*(GA) in payments,
                                                                                                 them from the general creditors.
                                                   where Wi is the percentage of total
• A Simple Look
                                                   senior claims accounted for by the /"'
at Depositor Preference
                                                   senior creditor (/ = FDIC, uninsured de-      • Unintended Effects
To understand the impact of depositor
                                                   posits [UD], and general creditor             of Depositor Preference
preference, it is useful to look at a sim-
                                                   claims [GCC]).                                The above example illustrates how de-
ple example of the bank receivership
                                                                                                 positor preference is intended to work.
process both before and after passage
                                                   To see how depositor preference is in-        However, general creditors of insured
ofOBRA93.6 We assume here that the
                                                   tended to work, consider the following        depositories will certainly respond to
administrative claims of the receiver
                                                   example. Let the value of collateralized      the changes in the priority of their
have already been paid. Above, we
                                                   assets and collateralized claims be           claims and the attendant increase in
show a simplified bank balance sheet
                                                   equal. Furthermore, let the total general     riskiness. At the very least, they will
with and without depositor preference.
                                                   asset pool equal $10 million and senior       charge the depository institution a
TABLE 1            PAYMENTS TO SENIOR CLAIMANTS                                                         concludes that depositor preference
                   (Millions of dollars)                                                                may provide marginal benefits to the
                                                                                                        deposit insurer and uninsured deposi-
                                                                    Depositor Preference                tors, but it also warns that each could
                 No Depositor Preference            Intended Outcome            Unintended Outcome      experience higher losses if enough non-
                   (GA = $10 Million)               (GA = $10 Million)          (GA = $9.16 Million)    deposit creditors secure their claims by
Claimant              Wi          Payment             Wi            Payment        Wi       Payment
                                                                                                        taking collateral.

FDIC                0.6667         $6,667          0.7273            $7,273      0.7273      $6,662
                                                                                                        • Conclusion
UD                  0.2500         $2,500          0.2727            $2,727      0.2727      $2,498     The overall impact of national depositor
GCC                0.0833          $0,833             —             $0,000         —         $0,000     preference is likely to be minimal.
                                                                                                        Clearly, the law will result in some
NOTES:                                                                                                  changes in the liability structure of
W, = Weight of the /''' claimant in the general asset pool.                                             banks. Depositors and the FDIC will
GA = General asset pool remaining after secured creditors' claim.
                                                                                                        benefit from these changes to the ex-
FDIC = Federal Deposit Insurance Corporation's claim.
                                                                                                        tent that nondeposit creditors serve as a
UD = Uninsured depositors' claim.
GCC = General creditors' claim.                                                                         loss buffer when a bank is closed. The
SOURCE: Author's calculations.                                                                          FDIC may also gain in another way.
                                                                                                        Deposit insurance premiums are assessed
                                                                                                        only on domestic deposits. Since deposi-
higher rate of interest to compensate                       buffer afforded by general creditor         tor preference raises a bank's cost of
for their increased risk of loss. As the                    claims will be reduced. Second, and         nondeposit funds relative to deposits, it
cost of nondeposit funds rises relative                     more important, the general asset pool      reduces the advantages of issuing sen-
to deposits, depositories will decrease                     available to pay unsecured claims will      ior nondeposit liabilities to avoid de-
their funding in nondeposit markets.                        also shrink. If enough general creditor     posit insurance assessments. This is
Thus, the loss buffer that nondeposit                       claims take collateral, the total loss      especially true if foreign deposits are
creditors afford to uninsured depositors                    exposure of the FDIC and uninsured          classified as nondeposit liabilities under
and the FDIC will be reduced.                               depositors could increase.                  the new law.

A second possible response by senior                        To see this, consider the example in the    On the flip side, nondeposit creditors will
nondeposit creditors would be to short-                     previous section. If $840,000 of gen-       not react passively to the subordination
en the average maturity of their claims.                    eral creditor claims become fully se-       of their claims. This means that while de-
By doing so, they would enhance their                       cured (that is, 100 percent collateral -    positor preference may produce some
ability to "run" on the institution if its                  ized) in response to the depositor          cost savings for the FDIC in the short
condition deteriorates. In fact, finan-                     preference law, then the general asset      term, the long-term benefits are likely to
cially distressed depositories may find                     pool available to pay the FDIC and un-      be greatly diminished. Moreover, if a suf-
it difficult or even impossible to issue                    insured depositors would be $9.16 mil-      ficient number of nondeposit creditors
unsecured nondeposit claims. This re-                       lion. The total payouts would then be       take collateral and hence convert their
sponse has two implications: First, if                      $6,662 million to the FDIC, $2,498 mil-     claims to ones senior to deposits, the
nondeposit creditors can effectively                        lion to uninsured depositors, and $0 to     losses of uninsured depositors and the
exit a troubled institution before it is                    general creditors. As a result, depositor   FDIC could actually increase.
closed, little or no loss cushion will be                   preference would increase the losses of
afforded to the uninsured depositors or                     the FDIC and uninsured depositors by
the FDIC by the general creditors. Sec-                     $5,000 and $2,000, respectively.
ond, the failure of nondeposit creditors
to renew their claims could trigger a                       A recent study of state depositor prefer-
liquidity crisis that would result in clo-                  ence laws finds that the unintended ef-
sure of the institution.9                                   fects negate most of the intended
                                                            ones.10 The authors conclude that in-
The third option for unsecured creditors                    troducing depositor preference at the
is to take collateral against their claim.                  federal level "would sharply increase
By becoming secured creditors, they                         the use of collateralization by nonde-
transform their claim into one that is                      posit creditors...." They also show that
senior (to the extent of the collateral) to                 the highest degree of collateralization
deposit claims. This in turn will have                      by nondeposit creditors in states with
two effects on the claims of uninsured                      depositor preference laws is in troubled
depositors and the FDIC. First, the loss                    and insolvent thrifts. Overall, the study
• Footnotes                                        6. For a more thorough presentation of how         9. The decision to close a bank is based on
1. The Office of Management and Budget's           depositor preference affects the cost of capi-     one of two measures of solvency: the inca-
estimate can be found in Statement 98 of the       tal for banks and federal deposit insurance,       pacity to pay obligations as they mature or
Shadow Financial Regulatory Committee,             see William P. Osterberg and James B. Thom-        book-value balance-sheet insolvency. Inabil-
"The New Depositor Preference Legislation,"        son, "Depositor Preference and the Cost of         ity to renew nondeposit credits could trigger
issued September 20,1993.                          Capital for Insured Depository Institutions,"      insolvency under the maturing obligations
                                                   Federal Reserve Bank of Cleveland, Working         test. See James B. Thomson, "Modeling the
2. 12U.S.C. 1821 (d)( 11). At the time na-
                                                   Paper 9405 (forthcoming).                          Bank Regulator's Closure Option: A Two-
tional depositor preference was enacted, 29
                                                                                                      Step Logit Regression Approach," Journal of
states had similar laws covering state-chartered   7. If CA > CC, then the excess collateral
                                                                                                      Financial Services Research, vol. 6, no. 1
banks and 18 had statutes covering state-          (CA - CC) is dumped into the general asset
                                                                                                      (May 1992), pp. 5-23.
chartered thrift institutions.                     pool for distribution to noncollateralized
3. The interim rule was issued because the         creditors. If CC > CA, then the ex post unse-      10. See Eric Hirschhorn and David Zervos,
law went into effect immediately upon enact-       cured claims (CC - CA) are lumped into the         "Policies to Change the Priority of Claimants:
ment of the legislation. Thus, the FDIC did        senior claim pool as a general creditor.           The Case of Depositor Preference Laws," Jour-
not have the luxury of issuing a rule for com-     8. The FDIC guarantees the principal and           nal of Financial Sendees Research, vol. 4, no.
ment and then implementing a revised ver-          interest of all deposit accounts up to $100,000.   1 (March 1990), pp. 111-26.
sion. See Federal Register, vol. 58, no. 155       When a bank enters receivership, it is appro-
(August 13, 1993), pp. 43,069 - 070. At the        priate to think of the FDIC as paying off the
time of this writing, the FDIC had not issued      insured depositors in exchange for their claim
its final ruling.                                  on the institution's assets. Hence, our discus-    James B. Thomson is an assistant vice presi-
                                                   sion of how depositor preference works re-         dent and economist at the Federal Reserve
4. Ibid.
                                                   fers to deposits as uninsured depositor claims     Bank of Cleveland.
5. In fact, the Shadow Financial Regulatory
                                                   and FDIC claims.                                       The views stated herein are those of the
Committee adopted this interpretation. See
"The New Depositor Preference Legislation"                                                            author and not necessarily those of the Fed-
(footnote 1).                                                                                         eral Reserve Bank of Cleveland or of the
                                                                                                      Board of Governors of the Federal Reserve

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