Federal Deposit Insurance Corporation
CI Minn: I n
L. William Seidman
OfHue of Research
mid Stiitisties.
Director
Wm. Roger Watson
Editor
John F. liovenxi
Editoriiil Conn
Frederick S. Cams
Man S. McCall
Lynn A. Nejezchleh
A d in ii i is trative
Malinger
Delia Voesar
Editorial Secretary
Ciithy Wright
Design and PiiHluction
Design anil Printing
Unit
The views expressed are
those of the authors and
do not necessarily reflect
official positions of (he
Federal Deposit Insur
ance Corporation. Arti
cles may be reprinted or
abstracted if the Review
and author are credited
Please provide the FDlC's
Office of Research and
Statistics with a copy of
any publications contain
ing reprinted material.
Single-copy subscrip
tions are available to the
publicfree of charge. Re
quests for subscriptions,
hack issues or address
changes should he mailed
to: FDiG Hanking Re
view, Office of Corporate
Communications, Fed
eral Deposit Insurance
Corporation, 550 17th
Street, NW, Washington,
DC 2(1429.
FDIG
Bankin;
Review
Fall 1988
Vol. 1, No. 1
Resolution Costs of Bank Failures page 1
by John F. Bovcnzi and Arthur J. Murton
The FDIC's failure-resolution costs for small banks that failed in 1985 and 1986 are estimated to be
roughly 30 percent of total failed-bank assets. Around that average there is a wide variance, ranging
from a low of two percent to a high of 64 percent. This study presents a formula used by the FD1C to
estimate the FDIC's failure-resolution costs for individual banks, based primarily on the banks'
asset-quality characteristics. These costs reflect the FDIC's liquidation experience. The analysis docs
not address the issue of determining what those assets would be worth in an ongoing institution. It is
shown that geographic differences play an important role in determining the FDIC's failure-resolution
costs. However, after accounting for differences in asset quality and location, other factors, such as the
presence of fraud or insider abuse, bank size (up to about 8500 million in total assets), a dependence
on agricultural lending, and different chartering authorities (state vs. national) are not important
factors in determining differences in failure-resolution costs. Deposit payoffs were more costly than
purchase-and-assumption agreements in 1985 and 1986 due to the relatively poorer asset quality of
the banks that were handled as payoffs. The paper concludes with a general overview of how the FDIC
uses this information to determine acceptable bids on different types of failure-resolution transac
tions.
Measuring the Interest-Rate Exposure of Financial Intermediaries page 14
by George E. French
This article explains the gap and duration methods of measuring the interest-rate exposure of financial
intermediaries, and discusses the uncertainties surrounding the measurement of interest-rate
exposure given the limited financial information regularly provided to regulators. Cap and duration
estimates of interest-rate exposure for FDIC-insured commercial banks, savings banks and FSLIC-
insured thrift institutions also are presented. These estimates indicate considerable interest-rate
exposure at some institutions, particularly thrift institutions; this indicates the need for continued
offsite regulatory monitoring of interest-rate exposure despite the inherent difficulties.
"Derivative" Mortgage Securities and Their Risk/Return Cliaracteristics page 2b
by Panos Koristas
The majority of residential mortgage loans originated in 1988 will be transformed into mortgage-
backed securities, a large part of which subsequently will be turned into "derivative" mortgage
instruments such as "strips," "REMICS," and "CMOs." In derivative products, cash flows from the
mortgage-backed securities are rearranged to suit the risk and maturity preferences of investors.
Some have viewed this process as not unlike the one in a supermarket where chickens are cut up
and packaged into pieces—a practice that not only satisfies the customer, but often brings in
more revenue than if the chickens had been sold whole. This article analyzes the risks and
rewards embodied in these new instmments under changing market and economic conditions.
Recent Developments Affecting Depository institutions page 34
by Benjamin B. Christopher
CI Minn: I n
L. William Seidman
OfHue of Research
mid Stiitisties.
Director
Wm. Roger Watson
Editor
John F. liovenxi
Editoriiil Conn
Frederick S. Cams
Man S. McCall
Lynn A. Nejezchleh
A d in ii i is trative
Malinger
Delia Voesar
Editorial Secretary
Ciithy Wright
Design and PiiHluction
Design anil Printing
Unit
The views expressed are
those of the authors and
do not necessarily reflect
official positions of (he
Federal Deposit Insur
ance Corporation. Arti
cles may be reprinted or
abstracted if the Review
and author are credited
Please provide the FDlC's
Office of Research and
Statistics with a copy of
any publications contain
ing reprinted material.
Single-copy subscrip
tions are available to the
publicfree of charge. Re
quests for subscriptions,
hack issues or address
changes should he mailed
to: FDiG Hanking Re
view, Office of Corporate
Communications, Fed
eral Deposit Insurance
Corporation, 550 17th
Street, NW, Washington,
DC 2(1429.
FDIG
Bankin;
Review
Fall 1988
Vol. 1, No. 1
Resolution Costs of Bank Failures page 1
by John F. Bovcnzi and Arthur J. Murton
The FDIC's failure-resolution costs for small banks that failed in 1985 and 1986 are estimated to be
roughly 30 percent of total failed-bank assets. Around that average there is a wide variance, ranging
from a low of two percent to a high of 64 percent. This study presents a formula used by the FD1C to
estimate the FDIC's failure-resolution costs for individual banks, based primarily on the banks'
asset-quality characteristics. These costs reflect the FDIC's liquidation experience. The analysis docs
not address the issue of determining what those assets would be worth in an ongoing institution. It is
shown that geographic differences play an important role in determining the FDIC's failure-resolution
costs. However, after accounting for differences in asset quality and location, other factors, such as the
presence of fraud or insider abuse, bank size (up to about 8500 million in total assets), a dependence
on agricultural lending, and different chartering authorities (state vs. national) are not important
factors in determining differences in failure-resolution costs. Deposit payoffs were more costly than
purchase-and-assumption agreements in 1985 and 1986 due to the relatively poorer asset quality of
the banks that were handled as payoffs. The paper concludes with a general overview of how the FDIC
uses this information to determine acceptable bids on different types of failure-resolution transac
tions.
Measuring the Interest-Rate Exposure of Financial Intermediaries page 14
by George E. French
This article explains the gap and duration methods of measuring the interest-rate exposure of financial
intermediaries, and discusses the uncertainties surrounding the measurement of interest-rate
exposure given the limited financial information regularly provided to regulators. Cap and duration
estimates of interest-rate exposure for FDIC-insured commercial banks, savings banks and FSLIC-
insured thrift institutions also are presented. These estimates indicate considerable interest-rate
exposure at some institutions, particularly thrift institutions; this indicates the need for continued
offsite regulatory monitoring of interest-rate exposure despite the inherent difficulties.
"Derivative" Mortgage Securities and Their Risk/Return Cliaracteristics page 2b
by Panos Koristas
The majority of residential mortgage loans originated in 1988 will be transformed into mortgage-
backed securities, a large part of which subsequently will be turned into "derivative" mortgage
instruments such as "strips," "REMICS," and "CMOs." In derivative products, cash flows from the
mortgage-backed securities are rearranged to suit the risk and maturity preferences of investors.
Some have viewed this process as not unlike the one in a supermarket where chickens are cut up
and packaged into pieces—a practice that not only satisfies the customer, but often brings in
more revenue than if the chickens had been sold whole. This article analyzes the risks and
rewards embodied in these new instmments under changing market and economic conditions.
Recent Developments Affecting Depository institutions page 34
by Benjamin B. Christopher
Bank-Failure Costs
Resolution Costs
of Bank Failures
by John F. Bovenzi and Arthur J. Murton*
Will Rogers once said: "The
business of government is
to keep the government
out of business—that is, unless busi
ness needs government aid." While
this statement was made with tongue
in cheek, there is little doubt that as
it relates to the federal deposit insur
ance agencies and our nation's bank
ing system, government is involved
in business in a big way. It is com
monplace to see headlines such as
the ones indicating a rescue opera
tion for First City Bancorporation
involving nearly Si billion in FDIC
aid. Or the headlines indicating a $4
billion cash outlay from the FDIC to
facilitate the closing and sale of the
banking subsidiaries of another large
Texas banking organization, First Re-
publicBank Corporation. Fortu
nately, most failing banks are not the
size of the First City and First Re
public banking organizations, which
have #12 billion and #28 billion in
total assets. Nevertheless, even if the
costs of most bank failures are mea
sured in the millions of dollars rather
than in the billions, we still are talk
ing about significant amounts of
money.
Last year 203 banks failed or re
quired FDIC assistance. This year again
over 200 failures are anticipated. In
each case, decisions must be made
regarding the appropriate and least
costly way of handling the situation,
In order to make such decisions the
FDIC must have a reasonably good
idea of what the costs of a particular
bank failure are likely to be and how
those costs may change depending on
how the situation is handled. The pur
pose of this article is: (1) to describe
some of the work being done at the
FDIC to estimate bank-failure costs;
[2) to ascertain which individual bank
characteristics help to explain varia
tions in costs among failed banks; and
(3) to explain how this information is
used to determine minimum accept
able bids on various types of failure-
resolution transactions.'
There are several important ben
efits that may arise from studying
resolution costs of bank failures. First,
the FDIC can better reduce its failure-
resolution costs the more it under
stands about the factors that influ
ence those costs. Second, an
understanding of bank-failure costs
may help provide a clearer picture of
the adequacy of the FDICfund. Third,
the ability to provide more detailed
information to the general public on
bank-failure costs may eliminate
some uncertainty in the minds of
possible acquirers of failed or failing
banks, thereby reducing the risk pre
mium they may require to engage in
such a transaction, which, in turn,
reduces the FDIC's costs. Addition
ally, this information may have im
plications for bank-closure policies
and the allocation and appropriate
uses of bank supervisory forces.
The paper is structured as follows.
The first section provides background
information on the FDIC's objectives
and the various options available to
the FDIC for handling bank failures.
The second section discusses the data
used in this study. Section three pro
vides general information on bank-
failure costs and discusses the rele
vant factors that help determine bank-
failure costs. In this section wedescribe
a model that we developed that can be
used to estimate bank-failure costs
based on individual bank characteris
tics. The fourthsection describes FDIC
procedures for determining acceptable
bids on various types of failure-
resolution transactions based on its
"cost test." The final section discusses
some of the implications of the results
of this analysis and prospects for fu
ture research.
Background on FDIC
Failure-Resolution
Policies and Procedures
The FDIC does not have the power
to close a bank. That power resides
with the chartering authority—either
the state banking commissioner if the
"John Bovenzi is the Deputy Director
and Arthur Murton is a financial economist in
the FDIC's Office of Research and Statistics.
The authors would like to thank Christopher
-lames for his help on this project.
'For readers interested in bidding on
failed hanks, we should note that while the
models presented in this report are used in
the FDIC's decision-making process, final de
cisions on asset sales are based primarily on
reviews conducted by the FDIC's Division of
Liquidation. Given the substantial variance in
bank-failure costs thai is not explained by the
model, these onsite evaluations often diverge
significantly from the cost estimates presented
in this report.
Resolution Costs
of Bank Failures
by John F. Bovenzi and Arthur J. Murton*
Will Rogers once said: "The
business of government is
to keep the government
out of business—that is, unless busi
ness needs government aid." While
this statement was made with tongue
in cheek, there is little doubt that as
it relates to the federal deposit insur
ance agencies and our nation's bank
ing system, government is involved
in business in a big way. It is com
monplace to see headlines such as
the ones indicating a rescue opera
tion for First City Bancorporation
involving nearly Si billion in FDIC
aid. Or the headlines indicating a $4
billion cash outlay from the FDIC to
facilitate the closing and sale of the
banking subsidiaries of another large
Texas banking organization, First Re-
publicBank Corporation. Fortu
nately, most failing banks are not the
size of the First City and First Re
public banking organizations, which
have #12 billion and #28 billion in
total assets. Nevertheless, even if the
costs of most bank failures are mea
sured in the millions of dollars rather
than in the billions, we still are talk
ing about significant amounts of
money.
Last year 203 banks failed or re
quired FDIC assistance. This year again
over 200 failures are anticipated. In
each case, decisions must be made
regarding the appropriate and least
costly way of handling the situation,
In order to make such decisions the
FDIC must have a reasonably good
idea of what the costs of a particular
bank failure are likely to be and how
those costs may change depending on
how the situation is handled. The pur
pose of this article is: (1) to describe
some of the work being done at the
FDIC to estimate bank-failure costs;
[2) to ascertain which individual bank
characteristics help to explain varia
tions in costs among failed banks; and
(3) to explain how this information is
used to determine minimum accept
able bids on various types of failure-
resolution transactions.'
There are several important ben
efits that may arise from studying
resolution costs of bank failures. First,
the FDIC can better reduce its failure-
resolution costs the more it under
stands about the factors that influ
ence those costs. Second, an
understanding of bank-failure costs
may help provide a clearer picture of
the adequacy of the FDICfund. Third,
the ability to provide more detailed
information to the general public on
bank-failure costs may eliminate
some uncertainty in the minds of
possible acquirers of failed or failing
banks, thereby reducing the risk pre
mium they may require to engage in
such a transaction, which, in turn,
reduces the FDIC's costs. Addition
ally, this information may have im
plications for bank-closure policies
and the allocation and appropriate
uses of bank supervisory forces.
The paper is structured as follows.
The first section provides background
information on the FDIC's objectives
and the various options available to
the FDIC for handling bank failures.
The second section discusses the data
used in this study. Section three pro
vides general information on bank-
failure costs and discusses the rele
vant factors that help determine bank-
failure costs. In this section wedescribe
a model that we developed that can be
used to estimate bank-failure costs
based on individual bank characteris
tics. The fourthsection describes FDIC
procedures for determining acceptable
bids on various types of failure-
resolution transactions based on its
"cost test." The final section discusses
some of the implications of the results
of this analysis and prospects for fu
ture research.
Background on FDIC
Failure-Resolution
Policies and Procedures
The FDIC does not have the power
to close a bank. That power resides
with the chartering authority—either
the state banking commissioner if the
"John Bovenzi is the Deputy Director
and Arthur Murton is a financial economist in
the FDIC's Office of Research and Statistics.
The authors would like to thank Christopher
-lames for his help on this project.
'For readers interested in bidding on
failed hanks, we should note that while the
models presented in this report are used in
the FDIC's decision-making process, final de
cisions on asset sales are based primarily on
reviews conducted by the FDIC's Division of
Liquidation. Given the substantial variance in
bank-failure costs thai is not explained by the
model, these onsite evaluations often diverge
significantly from the cost estimates presented
in this report.