When Financial Businesses Fail: Protection for Account Holders

When Financial Businesses Fail:
Protection for Account Holders
Walter W. Eubanks
Specialist in Economic Policy
Government and Finance Division
Summary
Lawmakers have long recognized the importance of protecting some forms of
financial savings from risk. Such vehicles clearly include deposits in banks and thrift
institutions and credit union “shares.” Remedial and other safety net features also cover
insurance contracts, certain securities accounts, and even defined-benefit pensions.
Questions over how to fund and guarantee Social Security, along with the troubles of
the Pension Benefit Guaranty Corporation, have renewed interest in these arrangements.
This report portrays the salient features and legislation of account protection provided
by the Federal Deposit Insurance Corporation, the National Credit Union Share
Insurance Fund, state insurance guaranty funds, the Securities Investor Protection
Corporation, the Pension Benefit Guaranty Corporation, and a discussion of the FDIC’s
Temporary Liquidity Guarantee Program that extends unlimited temporary deposit
guarantees to certain depositors and debt held in insured depository institutions. It ends
with a discussion of monoline insurance companies. Overall, it provides resources for
further analysis of each protective arrangement and will be updated as appropriate.
Analysis
Analysts and lawmakers view many financial businesses as having an important role
in the U.S. economy, receiving protection for their individual account holders against loss,
should the firms fail. Such protections exist both to protect the individuals from risks
they probably could not discern for themselves, and to protect the economy against the
effects of financial panics if failures occur. Panics, the attendant collapses of wealth, and
severe consequences for the economy occurred before Congress created federal deposit
insurance in 1934. Until the enactment of the Emergency Economic Stabilization Act
(EESA) of 2008, government policy protected customers of depository institutions —
banks, thrift institutions, and credit unions — in full for accounts up to $100,00 and up
to $250,000 for retirement accounts. But the enactment of EESA on September 23, 2008
immediately raised the maximum deposit insurance to $250,000, leaving retirement
accounts at $250,000 until December 31, 2009. Other institutions such as insurance
companies, securities broker/dealers, and many pension funds receive government or
government-sponsored guarantees on specified accounts.

This report provides a side-by-side summary of the major features of financial
institutions’ customer protection systems, reflecting safety-net provisions legislated over
time, usually in reaction to specific collapses. Besides these explicit guarantees,
regulatory bodies can attempt the rescue of failing financial enterprises, using many tools
authorized by laws and regulations and often acting in the background. Such tools include
liquidity lending, arranging memoranda of understanding, issuing cease and desist orders
against risky practices, and arranging mergers of weak entities into stronger institutions.
If the entire financial economy seems threatened by pending collapse of either a sizeable
financial institution that is “too large to fail,” or many financial businesses collectively,
the Federal Reserve (Fed) can step in as the lender of last resort to avert serious adverse
consequences for the economy (e.g., use of the Fed’s liberal bank liquidity policy
immediately after the 911 attacks, and currently the subprime meltdown led to failures of
institutions once believed to be too large to fail — Bear Stearns, Fannie Mae, Freddie
Mac and AIG, all of which were or are being assisted by the federal government).
Moreover, Congress may have to provide emergency funding when parts of the federal
safety net are under severe pressure. The cleanup of the savings and loan industry in the
1980s and early 1990s, for example, required appropriated funds plus a new deposit
insurance fund and regulator. A more recent example is the Emergency Economic
Stabilization Act of 2008 that provided $700 billion to purchase distressed assets such as
mortgage-backed securities and to make direct capital investments in troubled financial
institutions.
An important conceptual distinction between support structures is who ultimately
pays for the protection. Lawmakers originally created federal deposit insurance in a “user
fee” model of insurance, in which the government owned and operated each insurance
system and charged member banks for its use. Following the banking failures of the late

20^th century, legislation moved deposit protection part way toward an alternative “mutual”

model, in which the burden of financing the system falls more clearly on the banking
industry. Mutual institutions are owned by their customers, such as saving associations’
depositors and insurance companies’ policyholders. As a result, some analysts now claim
that the banking industry “owns” the deposit insurance funds in mutual mode. In reality,
the federal government still owns and operates them. That is so because in all depository
institution cases, the ultimate guarantor is the economic power of the federal government.
History has shown that deposit guarantees short of the federal level have universally been
inadequate to prevent panics, runs, and severe economic damage when called upon.¹
Industry-sponsored and state-level programs have contained the collapses of their covered
entities only if the damages have been small. Credit union share insurance, in contrast,
more nearly follows the mutual model. Likewise, state insurance company guaranty and
federally-sponsored securities investor protection arrangements follow the mutual model.
The troubled pension benefit arrangement, however, remains in user fee mode.
The following tabulation lists the major elements and components of these safety
nets. Table 1 outlines the support structures for accounts at depository institutions.
Table 2 does the same for the nondepository supports. Readers may obtain further
analysis of each system via the websites of the administering agencies noted.

¹ CRS Report RL31552, Deposit Insurance: The Government’s Role and Its Implications for
Funding, by Gillian Garcia, William Jackson, and Barbara Miles.

Table 1. Comparing Account Protection: Depository Institutions
FeatureBankDepositsThrift InstitutionDepositsCredit Union Shares
StatutoryFederal DepositSameFederal Credit Union Act
AuthorityInsurance Act(Amendment)
Original Date/1933/1991/2005/1934/1989/1991/2005/1970/2005/2008
Major20082008
Modification
Citations to64 Stat. 873;Same84 Stat. 994;
Authority and12 U.S.C. 1811 ff.12 U.S.C. 1781 ff; P.L.
OperationsP.L 110-343,110-343, Sec. 346A
Sec.346A
AdministratorIndependent agency:Independent agency:Independent agency:
Federal DepositFederal DepositNational Credit Union
InsuranceInsuranceAdministration manages
Corporation’s Corporation’s DepositNational Credit Union
Deposit InsuranceInsurance Fund.Share Insurance Fund.
Fund.
FundingBanks paySameAll federal and electing
assessments onstates may pay
deposits to maintainassessments; none
fund balance:recently. Contribution of
currently zero for all1% of credit union
but riskiest firms.“shares” required.
FederalPart of consolidatedSameMembers own off-budget
Budgetary Statusfederal budget.fund.
FederalUnlimited line ofSame $100 million line of credit
Governmentcredit with U.S.with U.S. Treasury; “full
BackstopTreasury untilfaith and credit of the

12/31/09; “full faithUnited States.”

and credit of the
United States.”
Risk-basedYes: cents more perSame No
Assessment$100 of covered
deposits.
Tax DeductionYes: BusinessSameNone usually since credit
for Assessment expense deductionunions are exempt from
for taxes.federal and most state
taxes.
Product LineNoneNoneNone
Differentiation
Coverage Limit$250,000 per accountSame$250,000 for standard
and no limit forshare account.
certain account.
^Source:^C^oⁿ^g^r^es^sⁱ^on^{al R}^e^s^earch^Serv^{ice, T}^h^{e L}ⁱ^brary^of^C^oⁿ^g^r^es^s^.

Table 2. Comparing Account Protection: Nondepository Institutions
FeatureInsurance Policies Securities AccountsPension Accounts
StatutoryState laws;Securities InvestorEmployee Retirement
AuthorityMcCarran-FergusonProtection Act ofIncome Security Act of
Act (59 Stat. 33,19701974; Consolidated

1945) removed mostAppropriations Act, 2001;

federal industryDeficit Reduction Act of
involvement. 2005.
Original Date/Various.19701974/1994/2000/2005
Major
Modification
Citations toState laws.84 Stat. 1636;88 Stat. 829;
Authority and15 U.S.C. 78aaa ff.29 U.S.C. 1001 ff.
Operations
AdministratorMulti stateNon-governmental“Self-supporting” federal
administrators andmembershipgovernment corporation:
non-profitcorporation, fundedPension Benefit Guaranty
associations ofby member securitiesCorporation.
licensed insurers;broker-dealers:
coordinated viaSecurities Investor
National AssociationProtection
of InsuranceCorporation.
Commissioners and
National Conference
of Insurance
Legislators.
FundingLicensed directAssessments onEmployers pay annual
insurers pay after members forpremium per participant:
actual insolvency; no“reserve” fund$30 minimum in single-
funds(s) generallyadvancing paymentsemployer/$8.00 flat in
exist.to claimants: flatmulti-employer plans.
$150 yearly per firm.
Corporation may
levy revenue-based
assessment, as in

1989 — 1995.

FederalNot applicable.Not a budgetaryOn-budget.
Budgetary Statusaccount.
FederalNone, except for a May borrow $1Borrowing or appropriation
Governmentprogram of terrorismbillion from U.S.has not covered fund
Backstopreinsurance.Treasury Departmentdeficits; lacks “full faith
through Securitiesand credit” backup.

and Exchange
Commission; lacks
“full faith and credit”
backup.

FeatureInsurance Policies Securities AccountsPension Accounts
Risk-basedNo.No.Yes: Underfunded single-
Assessmentemployer plans pay extra
$9/1,000 on unfunded
vested benefits, varying
with interest rates
Tax Deduction ofYes: Life insurers inEssentially notYes: Employers’ business
Assessment 45 states andapplicable, althoughexpense deduction for
property-liabilitybusiness expense taxfederal and state taxes.
insurers in 20 maydeduction is
deduct assessmentsnominally available.
from premium taxes;
business expense
deduction for federal
and state taxes.
Product LineInsurers are assessedNone.Program for single-
Differentiationby market share inemployer plans; another for
particular types ofmulti-employer plans.
insurance.
Coverage LimitCoverage limits varyStocks, bonds, andVaries. Single-employer
by statecash registered toplan basic benefits to
holders in closed$51,750 annually for
broker/dealers; retirees starting at age 65,
$500,000 of whichadjusted for age and
$100,000 may beinflation. Multi-employer
cash; not protectedplan formula is 100% of
against changingfirst $11 of monthly
market values.benefits per year of service
plus 75% of the next $33 of
such benefits, not adjusted.
^Source:^C^oⁿ^g^r^es^sⁱ^on^{al R}^e^s^earch^Serv^{ice, T}^h^{e L}ⁱ^brary^of^C^oⁿ^g^r^es^s^.
FDIC Temporary Liquidity Guarantee (TLG) Program
On October 23, 2008, in the midst of the current financial crisis, the Federal Deposit
Insurance Corporation announced its Temporary Liquidity Guarantee program to help
unfreeze the U.S. short term credit markets. At the time, financial institutions were not
lending to each other, especially in the commercial paper market, which was almost
completely frozen. The two-part program temporarily guarantees all new senior
unsecured debt and fully guarantees funds in certain non-interest bearing accounts at
FDIC-insured institutions issued between October 14, 2008 and June 30, 2009 with
guarantees expiring no later than June 30, 2012. The FDIC expects these guarantees
would restore the necessary confidence for investors to begin investing in obligations of
depository institutions. Evidence suggests that these shot-term markets are slowly
returning to normal after the TLG program was implemented.
The second part of the FDIC’s TLG program is to guarantee 100% of non-interest-
bearing transaction accounts held in insured depository institutions until December 31,

2009. This addresses the concern that many small business accounts, such as payroll
accounts, frequently exceed the current maximum deposit insurance limit of $250,000.
The TLG program is being paid for by additional fees placed on depository institutions
that use these guarantees, not taxpayers.²
Financial Guarantors (Monoline Insurance Companies)
Financial guarantors are insurance companies that insure the credit quality of
securities that banks, securities firms, insurance companies, among others hold as assets.³
Even though state insurance regulators have sole authority to supervise them, financial
guarantors’ safety and soundness may have a critical impact on the safety and soundness⁴
of all financial businesses including federal regulated banks. The failure of one or more
financial guarantors could possible bring about other financial business failures because
credit rated securities backed by guarantors’ insurance on, for example, a national bank’s
books would be downgraded, requiring the banks to add capital. If the bank is unable to
acquire the necessary capital, the bank could suffer losses or even fail due to the falling
prices of its insured assets, which might no longer cover its liabilities, including deposits.
Financial guarantors provide insurance against credit defaults of securities.
Specifically, they focus on insuring the timely payment of principal and interest on
securities, including municipal bonds, asset-backed securities and collateralized debt
obligations (CDOs). The guarantors’ insurance raises the credit rating of the underlying
securities, which in turn lowers the interest costs to the issuer and makes the securities
more attractive to a wider range of investors. The nine New York monoline insurance
companies insure $2.5 trillion of domestic and international debt. An increasing part of
this debt was CDOs backed by subprime residential mortgage-backed securities. Such
debt led to losses for these monoline companies because these securities were being sold
at substantial discounts. The growing possibility of more losses caused the rating
agencies to lower the treble A ratings of several of these financial insurance companies.
The treble A credit rating is required for the guarantors to offer treble A credit ratings on
securities issuers offer. Because some guarantors were downgraded, the securities they
insured are being downgraded as well, which means that banks, securities firms, and
insurance companies, among others holding these downgraded assets must increase their
capital as the price of these assets falls. New York state insurance regulators and the U.S.
Treasury are seeking ways to help these financial guarantors get recapitalized.

² Thecla Fabian, “FDIC Board Approves Formal Notice of Temporary Liquidity Guarantee
Program,” ^BN^{A Banki}^{ng Repor}^t, October 27, 2008, p. 714, and FDIC website at
[ h t t p : / / www.f d i c .gov/ n ews/ news/ p r e ss/ 2008/ pr 081105.ht ml ] .
³ While New York state supervises financial guarantors, it’s insurance guaranty funds do not
cover monoline insurance companies.
⁴ See the testimony of Patrick M. Parkinson, Deputy Director, Division of Research and Statistics
of the Board of Governors of the Federal Reserve System, before U.S. House of Representative,
the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises,
Committee on Financial Services, February 14, 2008.
[ ht t p: / / www.f e der a l r eser ve .gov/ newseve nt s/ t e st i mony/ par ki nson20080214a.ht m] .