Order Code RS21987 Updated February 29, 2008 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 Financial Guarantors (monoline insurance companies). 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. Government policy protects customers of depository institutions — banks, thrift institutions, and credit unions — in full for accounts up to $100,000 and up to $250,000 for retirement accounts. In addition, customers of insurance companies, securities broker/dealers, and many pension funds receive government or governmentsponsored 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, CRS-2 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). 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. Currently, severely underfunded defined benefit pension plans of steel, airline, and similar businesses suggest that the Pension Benefit Guaranty Corporation may require much future federal assistance.1 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 20th 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.2 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 in the CRS reports cited for further reading, or via the websites of the administering agencies noted. 1 See the CRS Current Legislative Issue entry, Pension Security and Retirement Savings, at [http://beta.crs.gov/cli/cli.aspx?PRDS_CLI_ITEM_ID=446]. 2 CRS Report RL31552, Deposit Insurance: The Government’s Role and Its Implications for Funding, by Gillian Garcia, William Jackson, and Barbara Miles. CRS-3 Table 1. Comparing Account Protection: Depository Institutions Bank Deposits Feature Thrift Institution Deposits Credit Union Shares Statutory Authority Federal Deposit Insurance Act Same Federal Credit Union Act (Amendment) Original Date/ Major Modification 1933/1991/2005 1934/1989/1991/2005 1970/2005 Citations to Authority and Operations 64 Stat. 873; 12 U.S.C. 1811 ff. Same 84 Stat. 994; 12 U.S.C. 1781 ff. Administrator Independent agency: Federal Deposit Insurance Corporation’s Deposit Insurance Fund. Independent agency: Federal Deposit Insurance Corporation’s Deposit Insurance Fund. Independent agency: National Credit Union Administration manages National Credit Union Share Insurance Fund. Funding Banks pay assessments on deposits to maintain fund balance: currently zero for all but riskiest firms. Same All federal and electing states may pay assessments; none recently. Contribution of 1% of credit union “shares” required. Federal Budgetary Status Part of consolidated federal budget. Same Members own offbudget fund. Federal Government Backstop $30 billion line of credit with U.S. Treasury; “full faith and credit of the United States.” Same $100 million line of credit with U.S. Treasury; “full faith and credit of the United States.” Risk-based Assessment Yes: a few cents more per $100 of covered deposits. Same No Tax Deduction for Assessment Yes: Business expense deduction for taxes. Same None usually since credit unions are exempt from federal and most state taxes. Product Line Differentiation None None None Coverage Limit $100,000 per account, and $250, 000 for retirement accounts. Same Same Source: Congressional Research Service, The Library of Congress. CRS-4 Table 2. Comparing Account Protection: Nondepository Institutions Feature Insurance Policies Securities Accounts Pension Accounts Statutory Authority State laws; McCarran-Ferguson Act (59 Stat. 33, 1945) removed most federal industry involvement. Securities Investor Protection Act of 1970 Employee Retirement Income Security Act of 1974; Consolidated Appropriations Act, 2001; Deficit Reduction Act of 2005. Original Date/ Major Modification Various. 1970 1974/1994/2000/2005 Citations to Authority and Operations State laws. 84 Stat. 1636; 15 U.S.C. 78aaa ff. 88 Stat. 829; 29 U.S.C. 1001 ff. Administrator Multi state administrators and non-profit associations of licensed insurers; coordinated via National Association of Insurance Commissioners and National Conference of Insurance Legislators. Non-governmental membership corporation, funded by member securities broker-dealers: Securities Investor Protection Corporation. “Self-supporting” federal government corporation: Pension Benefit Guaranty Corporation. Funding Licensed direct insurers pay after actual insolvency; no funds(s) generally exist. Assessments on members for “reserve” fund advancing payments to claimants: flat $150 yearly per firm. Corporation may levy revenue-based assessment, as in 1989 — 1995. Employers pay annual premium per participant: $30 minimum in singleemployer/$8.00 flat in multi-employer plans. Federal Budgetary Status Not applicable. Not a budgetary account. On-budget. Federal Government Backstop None, except for a program of terrorism reinsurance. May borrow $1 billion from U.S. Treasury Department through Securities and Exchange Commission; lacks “full faith and credit” backup. Borrowing or appropriation has not covered fund deficits; lacks “full faith and credit” backup. CRS-5 Feature Insurance Policies Securities Accounts Pension Accounts Risk-based Assessment No. No. Yes: Underfunded singleemployer plans pay extra $9/1,000 on unfunded vested benefits, varying with interest rates Tax Deduction of Assessment Yes: Life insurers in 45 states and property-liability insurers in 20 may deduct assessments from premium taxes; business expense deduction for federal and state taxes. Essentially not applicable, although business expense tax deduction is nominally available. Yes: Employers’ business expense deduction for federal and state taxes. Product Line Differentiation Insurers are assessed by market share in particular types of insurance. None. Program for singleemployer plans; another for multi-employer plans. Coverage Limit Coverage limits vary by state Stocks, bonds, and cash registered to holders in closed broker/dealers; $500,000 of which $100,000 may be cash; not protected against changing market values. Varies. Single-employer plan basic benefits to $51,750 annually for retirees starting at age 65, adjusted for age and inflation. Multi-employer plan formula is 100% of first $11 of monthly benefits per year of service plus 75% of the next $33 of such benefits, not adjusted. Source: Congressional Research Service, The Library of Congress. 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. Even though state insurance regulators have sole authority to supervise them3, financial guarantors’ safety and soundness may have a critical impact on the safety and soundness of all financial businesses including federal regulated banks.4 The failure of one or more 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, (continued...) CRS-6 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. For Further Reading CRS Report RL34364, Bond Insurers: Issues for the 110th Congress, by Baird Webel and Darryl E. Getter. CRS Report RS20724, Federal Deposit and Share Insurance: Proposals for Change, by Walter Eubanks. CRS Report RL32175, Insurance Guaranty Funds, by Baird Webel. CRS Report 95-118, Pension Benefit Guaranty Corporation: A Fact Sheet, by John Topoleski. CRS Report RS21741, Securities Investor Protection Corporation, by Gary Shorter. CRS Report RS22671, Terrorism Risk Insurance Program: Current Issues, Legislation, and Background, by Baird Webel. crsphpgw 4 (...continued) Committee on Financial Services, February 14, [http://www.federalreserve.gov/newsevents/testimony/parkinson20080214a.htm]. 2008.