Federal Deposit Insurance Corporation
Acting Ch airm an
Andrew C Hove, Jr.
Division of Research
and Statistics,
Director
Wm. Roger Watson
Bditor
George E. French
Editorial Committee
Fredericks. Cams
Gary S. Ftssef
Arthur J. Murton
Administrative
Manager
Detta Voesar
Editorial Secretary
Cathy Wright
Design and Production
Graphics and Distribution
The views expressed arc those
of the authors and do nor neces
sarily reflect official positions nf
the Federal Deposit Insurance
Corporation. Articles may be
reprinted ur abstracted if the
FDIC Banking Review and
authorW are credited. Please
provide the FDIC's Division of
Research and Statistics with a
copy of any publications con
taining reprinted material.
Single-copy subscriptions are
available to the public free of
charge. Requests for subscrip
tions, back issues or address
changes should be mailed to:
FDIC Banking Review, Office of
Corporate Communicanons,
Federal Deposit Insurance Cor
poration. 550 17th Street, N.W.,
Washington, D.C. 20429.
r_
Fall/Winter 1992
Vol. 5, No. 2
Table of Contents
Bank Failure Resolution, the Cost Test and the Entry and Exit of
Resources in the Banking Industry
by Frederick S. Cams and Lynn A. Nejezckkb pagel
FDIC cost considerations determine the "minimum acceptable bid" for a failed-bank franchise.
In competitive markets, however, the decision whether to continue operations depends upon
franchise value alone. Thus, for example, the FDIC's statutory cost test may dictate a purchase-
and-assumption transaction, even for an institution with negative franchise value. Using failed-
bank data, the authors find that the cost test may have interfered with efficient resource
adjustment in a sizable percentage of recent cases. While this conflict cannot be completely
avoided, the authors argue that a more explicit consideration of resource-adjustment effects could
help to strike an appropriate balance between the conflicting policy objectives.
The Bank Insurance Fund: Trends, Initiatives, and the Road Ahead
by Panos Konstas page 15
The changes to the financial condition of the Bank Insurance Fund (BIF) that have occurred over
the past decade and the recent measures taken to restore the BIF to financial viability are discussed
in this article. The author recommends that a "moving-average" approach to assessment policy
be implemented after the BIF reserve reaches its target ratio of 1.25 percent of insured deposits.
Acquisitions of Fuiled-Bank Deposits: In-Market vs. Out-of-Market
Cost Effects
by Neil B. Murphy page 24
Banks seeking to acquire an insured-deposit franchise from the FDIC establish their bids based
upon expected net future earnings from the acquisition. Does a high bid from an in-market bank
reflect cost efficiencies or gains from reducing the number of competitors in the market area?
Using standard econometric techniques and simulations of specific transactions, the author finds
that in-market bidders who close redundant branches can achieve substantial cost efficiencies.
While there may not be economies of scale as a bank expands, there appear to be economies of
scale as the typical branch expands.
Recent Developments Affecting Depository Institutions
by Benjamin B. Christopher page 34
This regular feature of the FDIC Banh fig Review contains information on regulatory agency actions,
state legislation and regulation, and articles and studies pertinent to banking and deposit insurance
issues.
Acting Ch airm an
Andrew C Hove, Jr.
Division of Research
and Statistics,
Director
Wm. Roger Watson
Bditor
George E. French
Editorial Committee
Fredericks. Cams
Gary S. Ftssef
Arthur J. Murton
Administrative
Manager
Detta Voesar
Editorial Secretary
Cathy Wright
Design and Production
Graphics and Distribution
The views expressed arc those
of the authors and do nor neces
sarily reflect official positions nf
the Federal Deposit Insurance
Corporation. Articles may be
reprinted ur abstracted if the
FDIC Banking Review and
authorW are credited. Please
provide the FDIC's Division of
Research and Statistics with a
copy of any publications con
taining reprinted material.
Single-copy subscriptions are
available to the public free of
charge. Requests for subscrip
tions, back issues or address
changes should be mailed to:
FDIC Banking Review, Office of
Corporate Communicanons,
Federal Deposit Insurance Cor
poration. 550 17th Street, N.W.,
Washington, D.C. 20429.
r_
Fall/Winter 1992
Vol. 5, No. 2
Table of Contents
Bank Failure Resolution, the Cost Test and the Entry and Exit of
Resources in the Banking Industry
by Frederick S. Cams and Lynn A. Nejezckkb pagel
FDIC cost considerations determine the "minimum acceptable bid" for a failed-bank franchise.
In competitive markets, however, the decision whether to continue operations depends upon
franchise value alone. Thus, for example, the FDIC's statutory cost test may dictate a purchase-
and-assumption transaction, even for an institution with negative franchise value. Using failed-
bank data, the authors find that the cost test may have interfered with efficient resource
adjustment in a sizable percentage of recent cases. While this conflict cannot be completely
avoided, the authors argue that a more explicit consideration of resource-adjustment effects could
help to strike an appropriate balance between the conflicting policy objectives.
The Bank Insurance Fund: Trends, Initiatives, and the Road Ahead
by Panos Konstas page 15
The changes to the financial condition of the Bank Insurance Fund (BIF) that have occurred over
the past decade and the recent measures taken to restore the BIF to financial viability are discussed
in this article. The author recommends that a "moving-average" approach to assessment policy
be implemented after the BIF reserve reaches its target ratio of 1.25 percent of insured deposits.
Acquisitions of Fuiled-Bank Deposits: In-Market vs. Out-of-Market
Cost Effects
by Neil B. Murphy page 24
Banks seeking to acquire an insured-deposit franchise from the FDIC establish their bids based
upon expected net future earnings from the acquisition. Does a high bid from an in-market bank
reflect cost efficiencies or gains from reducing the number of competitors in the market area?
Using standard econometric techniques and simulations of specific transactions, the author finds
that in-market bidders who close redundant branches can achieve substantial cost efficiencies.
While there may not be economies of scale as a bank expands, there appear to be economies of
scale as the typical branch expands.
Recent Developments Affecting Depository Institutions
by Benjamin B. Christopher page 34
This regular feature of the FDIC Banh fig Review contains information on regulatory agency actions,
state legislation and regulation, and articles and studies pertinent to banking and deposit insurance
issues.
Bank Failure Resolution
: e
the E iExit
e
by Frederick S. Garns and Lynn A. Nejezchleb*
Introduction
Between year-end 1986 and 1991,
the FDIC closed or assisted over 900
commercial banks with assets total
ling about $170 billion. That amount
is roughly twice the total failed-bank
assets handled by the FDIC during
the previous 53 years of the Agency's
existence. Stated differently, in just
five years more than five percent of
the banking industry's total assets
moved through the FDIC's failure-
resolution process.
With numbers like these, it is little
wonder that the failure-resolution
process is receiving considerable at
tention. Most of this attention has
focused on the costs of bank failures,
as reflected in the Bank Insurance
Fund balance. A number of inter
ested persons have pointed to closure
policies that provide defacto insurance
to uninsured depositors or to the lack
of timely closures of insolvent insti
tutions as being primarily responsible
for high insurance losses.
Another area of attention concerns
the effects of the failure-resolution
process on the remaining financial in
stitutions. Frequently, banks complain
that the failure-resolution process cre
ates unfair competitive advantages for
the acquirers of failed banks. A few
studies have looked at the effects of
the FDIC bidding procedures for failed
banks on the winning bidders. A
general question addressed in these
studies is whether the FDIC's auction
procedures result in wealth transfers
from the insurance fund to the ac
quirers of failed banks. While the
findings have been mixed, the studies
suggest that competitive bidding pro
cedures would ensure that the FDIC
receives the highest revenues and, at
the same time, would eliminate pos
sible subsidies to the acquirers of failed
banks, thereby eliminating any unfair
advantages over surviving competitors.
These two aspects of failure reso
lution — the cost of failures to the
insurance fund and their effect on the
acquirers and remaining market par
ticipants — are two sides of the same
coin. The sale of a failed-bank fran
chise has implications for both the
insurance fund and the remaining
financial institutions in the affected
market.
The sale of any failed firm's
franchise is the result of an interaction
between sellers and buyers. The sale
of a failed-bank franchise, however,
involves a unique restriction on the
seller. The minimum price the FDIC
will accept must meet a statutory cost
test. The cost test requires that the
minimum acceptable bid be such that
the cost of a franchise sale is less than
the cost the FDIC would incur if it
paid off only the insured deposits and
liquidated the assets itself.
"The authors are Senior Economise in the
Division of Research and Statistics and Special
Assistant to the Vice Chairman of the FDIC,
respectively. The authors thank Thomas Yeans
for expert research assistance and John Bovcn-
21, Gary Fissel, George Ftench, Alton Gilbert,
Eric Hirschhorn, Arthur Murton, participants in
the Office of Thrift Supervision's Seminar Series
and the staff of the FDIC's Division of Re
search and Statistics for valuable comments and
suggestions. An earlier version of this paper was
presented at the Federal Reserve Bank of Chi
cago's 1992 Conference on Bank Structure and
Competition.
For example, in an American Banker article
this was referred [o as a "survivor's hell." See
"Recapitalizing Failed Banks Creates a 'Sur
vivor's Hell'," American Banker, 3 January 1991,
p. 4. Also see "FDIC's Hospital Plan a Bitter
Pill for Some," The Washington Pan, 1 March
1992, p. HI.
See, for example, Christopher James and
Peggy Wier (1987), and John O'Keefe (1992).
' In addition, the FDIC Improvement Act of
1991 (FDICIA) introduced an additional re
quirement. A sale of the failed-bank franchise
must nor only be less expensive than a payoff,
it must also be the least expensive rype of
franchise sale. See Footnote 4 for a more com
plete explanation.
: e
the E iExit
e
by Frederick S. Garns and Lynn A. Nejezchleb*
Introduction
Between year-end 1986 and 1991,
the FDIC closed or assisted over 900
commercial banks with assets total
ling about $170 billion. That amount
is roughly twice the total failed-bank
assets handled by the FDIC during
the previous 53 years of the Agency's
existence. Stated differently, in just
five years more than five percent of
the banking industry's total assets
moved through the FDIC's failure-
resolution process.
With numbers like these, it is little
wonder that the failure-resolution
process is receiving considerable at
tention. Most of this attention has
focused on the costs of bank failures,
as reflected in the Bank Insurance
Fund balance. A number of inter
ested persons have pointed to closure
policies that provide defacto insurance
to uninsured depositors or to the lack
of timely closures of insolvent insti
tutions as being primarily responsible
for high insurance losses.
Another area of attention concerns
the effects of the failure-resolution
process on the remaining financial in
stitutions. Frequently, banks complain
that the failure-resolution process cre
ates unfair competitive advantages for
the acquirers of failed banks. A few
studies have looked at the effects of
the FDIC bidding procedures for failed
banks on the winning bidders. A
general question addressed in these
studies is whether the FDIC's auction
procedures result in wealth transfers
from the insurance fund to the ac
quirers of failed banks. While the
findings have been mixed, the studies
suggest that competitive bidding pro
cedures would ensure that the FDIC
receives the highest revenues and, at
the same time, would eliminate pos
sible subsidies to the acquirers of failed
banks, thereby eliminating any unfair
advantages over surviving competitors.
These two aspects of failure reso
lution — the cost of failures to the
insurance fund and their effect on the
acquirers and remaining market par
ticipants — are two sides of the same
coin. The sale of a failed-bank fran
chise has implications for both the
insurance fund and the remaining
financial institutions in the affected
market.
The sale of any failed firm's
franchise is the result of an interaction
between sellers and buyers. The sale
of a failed-bank franchise, however,
involves a unique restriction on the
seller. The minimum price the FDIC
will accept must meet a statutory cost
test. The cost test requires that the
minimum acceptable bid be such that
the cost of a franchise sale is less than
the cost the FDIC would incur if it
paid off only the insured deposits and
liquidated the assets itself.
"The authors are Senior Economise in the
Division of Research and Statistics and Special
Assistant to the Vice Chairman of the FDIC,
respectively. The authors thank Thomas Yeans
for expert research assistance and John Bovcn-
21, Gary Fissel, George Ftench, Alton Gilbert,
Eric Hirschhorn, Arthur Murton, participants in
the Office of Thrift Supervision's Seminar Series
and the staff of the FDIC's Division of Re
search and Statistics for valuable comments and
suggestions. An earlier version of this paper was
presented at the Federal Reserve Bank of Chi
cago's 1992 Conference on Bank Structure and
Competition.
For example, in an American Banker article
this was referred [o as a "survivor's hell." See
"Recapitalizing Failed Banks Creates a 'Sur
vivor's Hell'," American Banker, 3 January 1991,
p. 4. Also see "FDIC's Hospital Plan a Bitter
Pill for Some," The Washington Pan, 1 March
1992, p. HI.
See, for example, Christopher James and
Peggy Wier (1987), and John O'Keefe (1992).
' In addition, the FDIC Improvement Act of
1991 (FDICIA) introduced an additional re
quirement. A sale of the failed-bank franchise
must nor only be less expensive than a payoff,
it must also be the least expensive rype of
franchise sale. See Footnote 4 for a more com
plete explanation.