SPEAKERS       CONTENTS       INSERTS    
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VIEWPOINTS OF SELECT REGULATORS ON DEPOSIT INSURANCE REFORM

THURSDAY, JULY 26, 2001,
U.S. House of Representatives,
Subcommittee on Financial Institutions and Consumer Credit,
Committee on Financial Services,
Washington, DC.

    The subcommittee met, pursuant to call, at 10:05 a.m., in room 2128, Rayburn House Office Building, Hon. Spencer Bachus, [chairman of the subcommittee], presiding.

    Present: Chairman Bachus; Representatives Bereuter, Barr, Biggert, Grucci, Hart, Capito, Tiberi, Waters, C. Maloney of New York, Watt, Sherman, Meeks, Mascara, Moore, Gonzalez, Kanjorski, Hooley, Hinojosa and Lucas.

    Chairman BACHUS. The Subcommittee on Financial Institutions and Consumer Credit will come to order. Without objection, all Members' opening statements will be made a part of the record.

    The subcommittee meets today for a second hearing in this Congress on reforming the Federal deposit insurance system. At our first hearing on this subject in mid-May, Donna Tanoue, the outgoing Chairman of the Federal Deposit Insurance Corporation, (FDIC), presented the agency's recommendations for reform. Today, we will hear the perspectives of the other Federal bank regulators as well as the Treasury Department.
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    Since the subcommittee last met to consider these issues, there have been significant developments. First, President Bush chose to replace Ms. Tanoue at the FDIC. His choice was Don Powell, who has been confirmed by the Senate and is expected to assume his responsibilities shortly. My hope is that Chairman Powell will appear before the subcommittee in September to share his views on deposit insurance reform.

    Second, the FDIC released data last month reflecting that in the first quarter of this year, the ratio of reserves to insured deposits in the Bank Insurance Fund, (BIF), dropped from 1.35 percent to 1.32 percent. That ratio now stands at its lowest point since 1996. As most of the people in this room are well aware, once the number falls below the current ''hard target'' of 1.25 percent, every bank in America faces a 23-basis-point premium assessment. It is estimated that such an assessment would require banks to pay billions of dollars in premiums, a rude awakening after an extended period in which over 90 percent of banks paid no premiums at all. Such a massive outflow of funds from the banking system would curtail lending to consumers and small businesses with potentially devastating consequences for our economy and for communities and families throughout America.

    By contrast, the FDIC reports that the designated reserve ratio in the Savings Account Insurance Fund, (SAIF), which covers thrifts, held steady in the first quarter at 1.43 percent, unchanged from the last report at the end of 2000. Assuming that current trend continues, the possibility exists that banks will face sizable premium assessments at a time when most of their thrift counterparts are paying no premium.

    The significant growth in insured deposits that has triggered the decline in this reserve ratio in the first quarter is, in some respects, a ''good news/bad news'' story. The bad news is obvious for banks. They could find themselves on the receiving end of a multi-billion-dollar premium payout if current patterns persist and the current law remains in effect.
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    The ''good news'' is an apparent reversal of the trend of core deposits leaving the banking system in recent years, in search of higher returns elsewhere. As we all know, those higher returns did not always materialize.

    The outflow of deposits made it difficult for some banks to meet loan demand in their local communities. The $84 billion jump in insured deposits in the first quarter reported by FDIC—coming on the heels of a substantial increase in deposits in the fourth quarter of last year—is a welcome development for those concerned about the future of small community banks in America. Whether this flow of funds back into the banking system will be sustained or prove to be temporary, driven by investors seeking safe haven from more speculative investments, remains to be seen.

    Another contributor to the declining BIF ratio has been the subject of heated debate: large infusions of money by large brokerage firms from uninsured cash management accounts to insured accounts at banks owned by those same brokerage firms.

    Former Chairman Tanoue addressed the so-called ''free rider'' issue and made it a centerpiece in her reform proposal. I, for one Member, welcome that. We will learn at today's hearing whether the other banking regulators share her concerns in this regard.

    Let me now recognize the Ranking Minority Member, Ms. Waters, for her opening statement.

    Ms. WATERS. Good morning. I'd like to thank Chairman Bachus for calling this hearing, the second in a series on Federal deposit insurance reform. Deposit insurance has served America well for over 65 years. It has maintained public confidence in our banking system throughout times of prosperity and times that weren't so good.
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    It is important that we examine these issues closely in order to maintain and strengthen today's system for tomorrow's consumers. I look forward to hearing the testimony of the witnesses so that we can ensure that we have a deposit insurance system that will serve us well throughout the new millennium. I will yield back the balance of my time.

    Chairman BACHUS. I want to welcome our panel today. The first panelist, going from my left, is Governor Laurence Meyer, Governor of the Board of Governors of the Federal Reserve, who has testified before our subcommittee on several occasions, and we welcome you back and look forward to your testimony. It's always insightful. We appreciate that.

    We have a new Madam Assistant Secretary for Financial Institutions, Ms. Bair. We want to welcome you to the subcommittee and look forward to a long and cooperative relationship with you.

    Ms. BAIR. Thank you.

    Chairman BACHUS. I talked to her earlier and she brought her daughter to the Senate confirmation hearings, and I was, for one, looking forward to meeting her, but I think it's probably better that she's in a more comfortable environment than here.

    Ms. BAIR. There will be future opportunities, I'm sure.

    Chairman BACHUS. Thank you. I want to welcome back an old friend of this subcommittee, the Honorable John D. Hawke, the Comptroller of the Currency. And then the Honorable Ellen Seidman, who is the Director of the Office of Thrift Supervision, (OTS). And Ms. Seidman, I appreciate the service that you have given to the OTS.
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    At this time we will welcome opening statements from the witnesses. You do not have to limit yourselves to 5 minutes, if you want to go over that. We would rather hear from you rather than enforce some arbitrary limit, and we have time.

STATEMENT OF HON. LAURENCE H. MEYER, MEMBER, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM

    Mr. MEYER. Thank you. Mr. Chairman, Congresswoman Waters, Members of the subcommittee, it's a pleasure to appear before you to present the views of the Board of Governors of the Federal Reserve System on deposit insurance reform as proposed by the FDIC this past spring.

    Deposit insurance has played a key role, sometimes a critical one, in stabilizing banking and financial markets. In addition, deposit insurance has provided a safe and secure place for those households and small businesses with relatively modest amounts of financial assets to hold their transactions and other balances.

    But these benefits have not come without cost. The very same process that has ended deposit runs has made insured depositors largely indifferent to the risks taken by their banks. It has thus increased the ability of insured depository institutions to take risks while reducing market monitoring of that risk, necessitating greater governmental supervision. The crafting of reforms of the deposit insurance system must therefore struggle to balance the tradeoffs between these benefits and costs. The FDIC has made five broad recommendations.

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    The Board strongly supports the FDIC's proposal to merge the BIF and SAIF funds. Because the charters and operations of banks and thrifts have become similar, it makes no sense to continue the separate funds.

    The Board also strongly endorses the FDIC recommendations that would require a premium be imposed on every insured depository institution and eliminate the statutory restrictions on risk-based pricing. The current rule requires the Government to give away its valuable guarantee to well-capitalized and well-rated banks when the fund reserves meet some ceiling level. At the end of last year, 92 percent of banks and thrifts were paying no premium. Included in this group are new banks that have never paid any premium for their, in some cases substantial, coverage, and fast-growing entities whose past premiums were extraordinarily small relative to their current coverage.

    Although the establishment of a robust risk-based premium system would be technically difficult to design, a closer link between insurance premiums and individual bank and thrift risk would reduce banks' incentive to take risk. We note, however, that for risk-based premiums to do their job of inducing behavioral change, a substantial range of premiums is required. Thus, if a cap is required, as the FDIC recommends, it should be set quite high so that risk-based premiums can be as effective as possible in deterring excessive risk-taking.

    The current rules can result in sharp changes in premium when the reserves of the fund rise above or fall below 1.25 percent of insured deposits. These rules are clearly procyclical, lowering or eliminating fees in good times and abruptly increasing fees sharply in times of weakness. We strongly support the FDIC's proposal for increased flexibility and smoothing of premiums by the establishment of a targeted fund reserve range. However, we recommend that the FDIC's suggested target reserve range should be widened in order to further reduce the need to change premiums sharply.
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    The FDIC proposals would be coupled with rebates for stronger entities when the fund approaches the upper end of the target range, and surcharges when the fund trends below the lower end of the range. The FDIC also recommends that the rebates vary with the size and duration of past premiums and the scale of the current FDIC exposure to the entity. These proposals make considerable sense, and the Board endorses them.

    The FDIC recommends that the current $100,000 ceiling on insured deposits be indexed. The Board does not support this recommendation and believes that, at this time, the current ceiling should be maintained. In the Board's judgment, it is unlikely that increased coverage today, even by indexing, would add measurably to the stability of the banking system. Thus, the problem that increased coverage is designed to solve must be either with the individual depositor, the party originally intended to be protected by deposit insurance, or the individual bank or thrift, clearly, both of which would prefer higher coverage if there were no costs. But Congress needs to be clear about the problem for which increased coverage would be the solution.

    Our surveys of consumer finances suggest that depositors are adept at achieving the level of deposit insurance coverage they desire by opening multiple accounts. Such spreading of asset holdings is perfectly consistent with the counsel always given to investors to diversify their assets across different issuers.

    Does the problem to be solved by increased deposit insurance coverage concern the individual depository institutions? If so, the problem necessarily would be concentrated at smaller banks that generally do not have access to the money market or to foreign branch networks for supplementary funds. Since the mid-1990s, and adjusted for the effect of mergers, the smaller banks, those below the largest 1,000, have actually grown almost twice as rapidly as all banks. Most important, the uninsured deposits at the smaller banks have grown nearly twice as rapidly, over a 20 percent annual rate, compared to the larger banks. Clearly, small banks have a demonstrated skill and ability to compete for uninsured deposits.
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    With no obvious problem to be solved, the Board, as I noted, has concluded that there is not a case for increasing the current $100,000 level for insured deposits, even by indexing. There may come a time when the Board finds that households and businesses with modest resources are finding difficulty in placing their funds in safe vehicles, and/or that there is a reason to be concerned that the level of deposit coverage could endanger financial stability. Should either of those events occur, the Board would call our concerns to the attention of Congress and support adjustments to the ceiling by indexing or other methods.

    Thank you.

    Chairman BACHUS. Madam Assistant Secretary Bair.

STATEMENT OF HON. SHEILA C. BAIR, ASSISTANT SECRETARY FOR FINANCIAL INSTITUTIONS, U.S. DEPARTMENT OF THE TREASURY

    Ms. BAIR. Thank you, Mr. Chairman, Congresswoman Waters, and Members of the subcommittee, I appreciate the opportunity to comment on the Federal Deposit Insurance Corporation's recent paper recommending reform of the deposit insurance system.

    The Treasury Department has a substantial interest in this issue, as we have a critical role to play in deposit insurance. The deposit insurance funds have authority to borrow up to $30 billion from the U.S. Treasury. In addition, Congress has assigned to the Secretary of the Treasury the final responsibility for determining whether the resolution of a failing bank poses a systemic risk to the financial system.
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    My comments this morning will be general in nature, focusing on the key policy issues raised in the FDIC paper, and I would add that even though we are not in complete agreement with those recommendations, we think it's an excellent piece of work. The FDIC staff should be commended. It certainly provides an excellent starting point, a framework for considering this important issue.

    We are in general agreement with the FDIC report on three points. First, the potential procyclical effects of deposit insurance pricing and reserving should be reduced. Reserves should be allowed to grow when conditions are good in order to better absorb losses under adverse conditions without sharp increases in premiums. Allowing growth above a designated reserve ratio in good times or growth within a wide range would afford greater room for the insurance fund to handle bank failures without exhausting its resources. It also would allow for more stable premiums that would smooth over time the costs borne by the industry.

    Second, all insured depository institutions should pay premiums on current deposits, with potential rebates taking into account each institution's recent history of premium payments. Banks and thrifts benefit every day from deposit insurance, and they should compensate the FDIC for that benefit, preferably through relatively small, steady premiums. Most banks and thrifts now pay no premiums for deposit insurance, which creates incentives to increase deposits and thus raises the FDIC's uncompensated risk exposure.

    Third, the bank and thrift insurance funds should be merged. A larger combined insurance fund would have a greater ability to diversify its risks than either fund separately. A merger would underscore the fact that BIF and SAIF are already hybrid funds. Each one insures the deposits of commercial banks, savings banks, and savings associations.
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    We have different views from the FDIC report in two areas. First, while we agree with the FDIC report on the conceptual appeal of risk-based premiums, at this stage we would give priority to reforms that would charge every institution a premium on current deposits that is relatively stable over time. We would defer development of a new risk-based premium structure, a process that promises to be complex and time consuming, for a later time.

    Second, and most importantly, we have a different view with respect to insurance coverage. We believe that the deposit insurance coverage level should remain unchanged. We see no clear evidence that the current limit on deposit insurance coverage is burdensome to consumers, nor do we see clear evidence that increasing coverage across the board would enhance competition for the banking industry. Moreover, an increase in the coverage level would increase risks to the FDIC and ultimately taxpayers. In other words, there would be little if any tangible benefit and definite risk and excess costs to the fund and ultimately taxpayers.

    Finally, two issues not addressed in the FDIC report should be considered. While we recommend that all institutions pay premiums assessed on current deposits, we also feel that it would be a missed opportunity not to consider what should constitute the assessment base. In particular, reform efforts should consider whether the existing assessment base should be modified to account for the effect of liability structure on FDIC's expected losses.

    Also, we support Comptroller Hawke's and Director Seidman's call for addressing the uneven distribution of supervision costs between national and State-chartered banks. We believe that the Office of the Comptroller of the Currency's proposal is an interesting approach that deserves further consideration, and there may be other approaches and considerations that should also be explored.
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    We look forward to working with the incoming FDIC Chairman Powell and the FDIC Board to devise a solution to this problem.

    Thank you, Mr. Chairman, again for the opportunity to appear before you today, and I look forward to working with you in my new capacity.

    Chairman BACHUS. We appreciate your testimony.

    Comptroller John Hawke.

STATEMENT OF HON. JOHN D. HAWKE, JR., COMPTROLLER, OFFICE OF THE COMPTROLLER OF THE CURRENCY

    Mr. HAWKE. Thank you, Chairman Bachus, Congresswoman Waters and Members of the subcommittee, I appreciate this opportunity to discuss reform of our Federal deposit insurance system. Too often, reform occurs against the backdrop of a crisis. Fortunately, we are not in that position today. The deposit insurance funds and the banking industry are strong. Nevertheless, the flaws in the current deposit insurance system pose an unnecessary risk to the stability of the banking system and so merit a careful and timely review by the Congress.

    Let me summarize our positions on the major issues that have been raised in connection with reform proposals. We think the Bank Insurance Fund and the Savings Association Insurance Fund should be merged. A merged fund would enable the FDIC to operate more efficiently and to realize the benefits of diversification.
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    Deposit insurance premiums should be more sensitive to risk.

    Chairman BACHUS. Comptroller, several on the panel are having problems hearing you. I don't know whether that mike is on. If you'll just pull it closer. I think there's something wrong with the mike.

    Ms. BAIR. Do you want to use mine?

    Chairman BACHUS. If you can just substitute.

    Mr. HAWKE. Thank you.

    Chairman BACHUS. Oh, that's much better.

    Mr. HAWKE. Saved by the Treasury Department once again.

    [Laughter.]

    Mr. HAWKE. Deposit insurance premiums should be more sensitive to risk. Today, 92 percent of all insured institutions pay no premiums, yet common experience, as well as the markets, tell us that these institutions have widely varying risk characteristics.

    The requirement that the premium for banks in the lowest risk category be set at zero whenever the insurance fund reserve ratio equals or exceeds 1.25 percent of insured deposits should, in our view, be eliminated. Furthermore, we believe that to compensate the Government for the benefits conferred by deposit insurance on all banks, even the least risky banks should pay some reasonable minimum insurance premium.
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    We strongly support eliminating the current designated reserve ratio (DRR) of 1.25 percent of insured deposits. Instead, we favor empowering the FDIC to establish a range for the fund based on the FDIC's periodic evaluation of the risks borne by the fund and its assessment of potential losses. The FDIC should have the authority to pay rebates when the upper end of the range is exceeded and to impose surcharges when the ratio falls below the lower end of the range.

    We see no compelling case for an increase in deposit insurance coverage. There is no evidence that depositors are demanding increased coverage, nor is there a reliable basis for projecting whether an increase would bring new deposits into the system or simply result in a disruptive reshuffling of deposits among banks.

    There is one further set of issues that should be considered in the context of deposit insurance reform, in our view: the way the insurance fund is used, and should be used, to support the cost of bank supervision and the inequitable treatment of national banks in the way the BIF is currently used to pay the costs of supervision of State banks. These same issues apply to the way the SAIF fund is used with respect to thrift institutions.

    Under the current system, the FDIC draws on the insurance funds for about $600 million a year to fund the cost of its supervision of State non-member banks, that is, its costs of performing for State banks exactly those functions that the OCC performs for national banks. None of these costs are passed on to State banks in the form of direct assessments. By contrast, the OCC must charge national banks directly for the full cost of their supervision.

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    This disparity is compounded by the fact that more than half of the funds spent by the FDIC for Federal supervision of State non-member banks are attributable directly to the accumulated contributions of national banks to the insurance fund. Thus, the earnings of a fund that has been built up by all banks finance the supervisory costs of only a portion of the banking industry. In other words, for every dollar that the FDIC spends on the supervision of State banks, national banks, by our estimates, effectively contribute about 55 cents. And, that is in addition to paying the full cost of their own supervision to the OCC.

    Fee disparity presents a constant incentive for national banks to convert to the heavily-subsidized State charter. And, that incentive can be strongest when the banking system is under stress and the OCC faces the need to expand its supervisory resources—and thus its assessments—to deal with an increased level of problem banks.

    A key principle at the heart of deposit insurance reform is that the premiums paid by individual institutions should be closely related to the expected costs they impose on the funds. The objective is to identify and eliminate subsidies in the current system that, among other things, result in healthy, well-managed banks bearing the costs and risks presented by less well-managed. riskier banks. Similarly, bank supervision should not be based on a system of subsidies—such as those embedded in the current deposit insurance system—that result in national banks paying a substantial portion of the FDIC's cost of supervising State banks, because one of the main purposes of bank supervision is to protect the insurance fund. Ensuring that supervision is funded in a fair and equitable manner is inextricably related to the subject of deposit insurance reform.

    Attached to my written testimony is a paper that discusses the disparity in funding supervision in greater detail and proposes a remedy. We believe it would make sense to extend the existing arrangement to cover the costs of both State and national bank supervision from the FDIC fund, just as the fund today is used to cover the FDIC's costs of supervision. In other words, instead of funding supervision through direct assessments on banks, we propose that it be funded by payments to supervisors from the insurance fund, to which all banks contribute. This would ensure that all supervisors have access to the resources needed to deal with stresses in the system and could eliminate the perverse situation we have today in which our resources can be significantly depleted at the very time when the heaviest supervisory demands may be placed on us.
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    Thank you, Mr. Chairman.

    Chairman BACHUS. Thank you.

    Director Ellen Seidman.

STATEMENT OF HON. ELLEN SEIDMAN, DIRECTOR, OFFICE OF THRIFT SUPERVISION

    Ms. SEIDMAN. Thank you. Good morning, Chairman Bachus, Ranking Member Waters, and Members of the subcommittee. Thank you for the opportunity to testify about Federal deposit insurance reform.

    Over the past several years, those of us who have worked closely with the deposit insurance system have come to realize that while it is very important to serve the American people well, it is not optimal. Several areas are in need of reform if the system is to continue to serve the American people.

    The current economic period, with few failures and adequate reserves, provides a perfect opportunity to improve the system. The FDIC has done a fine job of both laying out the areas in which the system needs improvement and suggesting possible solutions. Nevertheless, I believe there are some refinements in thinking about risk parameters that might usefully be added to the discussion. And there is one additional issue—how supervisory costs are paid for—that needs to be part of the discussion of deposit insurance reform.
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    The FDIC has identified four areas of weakness in the Federal deposit insurance system: Maintenance of two separate funds that provide identical insurance; inadequate pricing of insurance risks, which distorts incentives and increases moral hazard; excessive premium volatility and a tendency for premiums to increase in economic downturns; and coverage levels that do not adjust on a regular basis.

    On the first point, the FDIC recommends merging the funds. We agree. There are still very real differences between the operations of banks and thrifts, who remain overwhelmingly residential mortgage lenders. Nevertheless, experience since the BIF and SAIF were established in 1989 argues strongly in favor of fund merger. Because, while the differences between banks and thrifts remain, those between the BIF and the SAIF have become increasingly artificial and tenuous.

    The two funds no longer insure distinct types of institutions, with many banks and thrifts holding deposits insured by both funds. The funds provide identical products. Yet keeping them separate raises the possibility of premium differentials that could handicap institutions that happen to be insured by the fund that charges the higher premiums.

    Industry consolidation has also increased the funds' exposure to their largest institutions. Merging the funds will alleviate these problems and strengthen the entire system by diversifying risks and eliminating the possibility of fund premium differentials.

    To address the inadequate pricing of insurance risks, the FDIC recommends implementing a system of risk-based premiums under which all institutions would be required to pay annually for the cost of insurance. I believe this is an extremely important part of comprehensive reform. Deposit insurance is a valuable good to institutions as well as to depositors. And like all casualty insurance, it should be paid for even if the eventuality insured against does not arise.
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    The most glaring problem in our current system is that it provides free deposit insurance coverage to the vast majority of institutions. Risk-based premiums would provide risk management incentives to institutions and allocate insurance costs based on the individual institution's risk profile. The system that prices appropriately would reward those who minimize fund exposure, but not impose too great a cost on those with a more aggressive, but still not unreasonable risk profile.

    Implementing an effective risk-based system will entail enhancing the current risk groupings for insured institutions. The FDIC's proposed scorecard is an attractive approach for refining existing risk groupings. The approach permits the incorporation of information beyond the prompt-corrective action (PCA) category and safety and soundness ratings into the risk classifications. This is increasingly important as non-traditional activities and funding, including asset securitization and collateralized funding sources, play a greater role in defining the relationship between deposits and the risk of loss to the fund.

    While the FDIC's approach is a good start, my experience over the past several years leads me to be interested in an enhancement that would focus on whether an institution, particularly a larger institution, presents a heightened risk of sudden failure. Sudden failure presents a problem that often frustrates the use of supervisory tools. A sudden failure can put maximum pressure not only on the deposit insurance fund, but also on the financial system as a whole.

    One way to address this issue would be to identify indicia of high risk for sudden failure and charge higher premiums for those who present such risks. This could help discourage such risks as well as shift the costs of sudden failure risks to those who take them.
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    The current pricing structure, which restricts how the FDIC sets fund targets and insurance premiums, also tends to promote premium volatility and make the system procyclical. In good times, the FDIC levies no premiums on most institutions. When the system is under stress projected to last more than a year, the FDIC is required to charge high premiums, which can exacerbate problems at weak institutions and reduce lending at sound ones.

    Increasing the FDIC's flexibility to set fund targets and premiums would reduce premium volatility and institutions' exposure to overall economic conditions and to sectoral industry problems. Authorizing the FDIC to rebate excess funds is also an important element of an effective risk-based pricing system, as it allows the FDIC to charge premiums to all institutions at all times, but also avoids the possibility of the fund building to an excessive level.

    I believe the most important point in addressing the issue of raising or indexing deposit insurance coverage levels is not whether it should be done, but how and when. Improved risk-based pricing and other reforms should be regarded as preconditions to even considering any action to raise or index the deposit insurance ceiling. Optimally, any action to increase deposit insurance coverage levels would be considered only as a part of the comprehensive deposit insurance reform package.

    The final point I want to address is the importance of allocating costs within the insurance system based on a structure that preserves the integrity of the system's pricing mechanism. Currently more than 40 percent of the FDIC's operating budget, which comes from the insurance funds, is used to pay for the supervisory costs relating solely to the FDIC's role as primary Federal regulator of State non-member banks. This is particularly ironic as premiums paid by OTS and OCC-supervised institutions and the earnings on those premiums account for the bulk of the current balance of the insurance fund.
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    Whether the costs of day-to-day bank supervision should be paid from the insurance funds can certainly be debated. However, I think there are really only two logical conclusions. Either all bank supervision is an insurance function for all charters, in which case all supervisory costs, Federal and State, should be paid from the insurance funds, or it is not. And if it is not, the only costs of supervision that should be paid from the insurance funds are the often considerable costs that arise when there is a higher risk of failure. And in such cases, again, all supervisory costs, not just those of the FDIC, should be paid from the insurance fund.

    Since the issue affects the proper pricing of insurance, it is an integral element in getting deposit insurance reform right.

    I thank you for this opportunity to testify on the subject of Federal deposit insurance reform. As you know, this may be my last opportunity to testify before this subcommittee. I want to thank each and every one of you for the opportunity to work with you over the past 3 1/2 years. I've enjoyed my time as OTS Director, and I appreciate having had the opportunity to meet individually with many of you to discuss some of the issues facing the thrift industry, OTS, and the financial system as a whole. Thank you very much.

    Chairman BACHUS. Thank you.

    We certainly appreciate the testimony of all our witnesses. Let me read back over just a portion of Governor Meyer's testimony. And I'd like maybe a comment on this issue. You said: ''At the end of last year, 92 percent of banks and thrifts were paying no premium. Included in this group were banks that have never paid any premium for their, in some cases substantial, coverage and fast-growing entities whose past premiums were extraordinarily small relative to their current coverage. We believe that these anomalies were never intended by the framers of the Deposit Insurance Fund Act of 1996 and should be addressed by the Congress.''
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    What are your suggestions for Congress addressing this change?

    Mr. MEYER. I think that, first of all, all banks should have to pay a premium, as opposed to now, where we have 92 percent of banks paying zero premium. And the way this is accomplished in the FDIC proposal is to have a range, rather than a point. And as long as the fund was within that range, the premiums are stable and all the banks are paying.

    If the reserves would go above the upper end, then there would be a flexible approach to gradually returning the funds to within that range by rebates. But those rebates would be small enough so that the banks would generally still be paying some premium, and we would be having both risk-based premiums and never having a zero cost for the Federal guarantee.

    Chairman BACHUS. Thank you.

    OK, Assistant Secretary.

    Ms. BAIR. We would certainly agree that the current statutory restriction on the FDIC's inability to charge premiums to well-capitalized banks that have a high CAMEL rating be eliminated. All banks pose some risk to the fund. All banks derive a benefit from deposit insurance, and all banks should pay a premium.

    Chairman BACHUS. Comptroller Hawke.

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    Mr. HAWKE. I would just note, Mr. Chairman, that the so-called ''free rider'' problem that you're alluding to of banks getting the benefit of deposit insurance despite never having paid into the fund is kind of a slippery issue to deal with. Banks that have paid into the fund over the years have had the benefit of deposit insurance in return. It is a little bit like a term life insurance policy, though, where once the policy comes to an end, you generally have to pay more premium. So, any bank that has increased its deposits at a time when it isn't paying any premiums is, in a sense, getting a free ride.

    I think the real problem here is not the free ride. It's the fact that we have a hard-wired designated reserve ratio of 1.25 percent that really aggravates the problem. Banks that have paid in over the years see the potential for dilution of the fund down below that reserve ratio, with the consequent imposition of costs on them, and they understandably are concerned about that. We would prefer to see the 1.25 ratio eliminated and instead have the FDIC set a range for the fund, which I think would mitigate to a great extent the concerns about free riders. Of course, that should be combined with a new approach to premium setting and a basic minimum premium for the benefit of deposit insurance.

    Chairman BACHUS. Director Seidman.

    Ms. SEIDMAN. I think substantively, everything has been said. I would like to say that this is a very good example of how everything is interconnected. For example, simply removing the restriction that the 1996 Act put on the FDIC's ability to charge premiums when the fund is at 1.25 percent will generate new problems, and in particular, could generate very fast fund growth.

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    So I think that it really is a good example of the interconnectedness of the whole system.

    Chairman BACHUS. The subcommittee assembled at least one estimate of the cost of the premiums. I almost hesitate to use this figure, but I'm going to throw it out—$65 billion of premiums. When I first saw that, I questioned it. I sent it back and said, this can't be right. But apparently, that would be the cost of tripping that 1.25. But, do you have a comment? Have the agencies looked at the actual cost?

    Ms. SEIDMAN. Let me just say that I was surprised when I saw that number also and traced it back to what, I think, was to some extent a piece of rhetoric in the FDIC's original options paper. It is a calculation that starts with the fund ratio not only falling down below 1.25, but falling low enough for long enough that the trigger that says you have to do 23 basis points would come into play. As you know, if, for example, the fund goes down to 1.22, that trigger will probably not come into play. You'll be able to have a much smaller premium amount that will bring it back to 1.25 within a year.

    So first it assumes that it falls low enough for long enough so that the projection is you can't bring it back within a year at anything less than 23 basis points. The 23 basis points generates about $7 billion in premiums. And the theory is that that full $7 billion would then, with a multiplier effect, result in $65 billion less lending.

    Well, the problem is that the full multiplier effect is also subject to a lot of questions. First of all, it is quite clear that any number of banks would react to having to pay greater premiums the way they react to any increase in cost—they reduce other costs, they reduce dividends, they do something other than reduce lending. Second, the multiplier is largely an effect of the capital of the bank. In the current situation, many banks are heavily overcapitalized, and it is therefore unclear that the full multiplier would apply in any event. And third, banks might take the premium increase out of some other part of their operations, not lending.
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    So, I think it is a number that got thrown out there. It's a very big number. It's a very scary number. I think it's one of these numbers where a whole chain of very bad things all have to occur for it to really be true. But I do think, again, it is a reason for us to think about the kind of structure we've created and to recognize that while $65 billion may not be the number, it is likely that some decline in lending would indeed, occur.

    Chairman BACHUS. I appreciate that. Let me compliment you on that answer. Does any other panelist wish to comment?

    Ms. BAIR. I would just say whatever the right number is, we need to get rid of the 23 basis point cliff. I think that's the important thing, especially for small banks. You'd be taking tremendous amounts of capital out to rebuild the fund, probably in an economic downturn, which is the worst possible time to be taking the money out. So I think, again, I would agree with Ellen, whatever the right number is, we need to get rid of that cliff.

    Chairman BACHUS. All right. Because I think we know that these deposits are fleeing the stock market on a downturn and they're going back to deposits. So it would occur in all likelihood during a downdraft in the economy.

    Governor Meyer.

    Mr. MEYER. I certainly agree that we should get rid of the cliff. We don't want to extend that argument and say, therefore, banks shouldn't have to pay for deposit insurance.
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    Chairman BACHUS. Thank you.

    The Ranking Member is recognized.

    Ms. WATERS. Thank you very much. I too, would like to thank our panelists today for sharing with us the information they have shared relative to reform of Federal deposit insurance.

    I'd like to know what risk factors do you believe should be used in determining risk-based premiums. I'd like you to be as specific as you can be. I'd like to know what factors should be accorded the most weight in determining deposit insurance rates. And would you consider certain activities to be part of that risk calculation? What behaviors would you seek to discourage by classifying them as risks? And if you don't mind, I'd like you to discuss this in relationship to the expanded activities of financial institutions, such as proposed real estate brokerage and management. I'll start with the Honorable John Hawke.

    Mr. HAWKE. Thank you, Congresswoman Waters. I think your question shows how complex the issue of setting truly risk-related deposit insurance premiums is. A risk-related premium system that is really prospective would have to get into enormous detail, looking at the quality and risk presented by different kinds of assets. That is one of the reasons we think that what's really needed here is a better tuning of the existing system, which is essentially based on a matrix that takes into account the CAMEL rating of the institution and the capital adequacy level of the institution. It is risk-related, but it's not prospective in nature the way I think you were suggesting it might be done.
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    The real problem with the risk relationship in the present system is that the matrix is too coarse. It treats 92 percent of the banks as presenting an equivalent risk to the fund when we know, and the market tells us, that there are very significant variations in the risks presented by those banks.

    So we are not proposing that the FDIC attempt to create a very finely tuned, forward-looking mechanism for determining risk, for example, along the lines of what the Basel Committee is presently considering, which is enormously complicated, and looks at the prospective risks, the expected loss and unexpected loss that attach to different types of assets.

    Ms. WATERS. I'd like to hear from Assistant Secretary Bair on that question.

    Ms. BAIR. Thank you, Congresswoman. The Treasury Department has a slightly different view on the necessity for extending risk-based premiums at this time.

    We believe that that process, though in an ideal world, would have premiums that accurately reflect the risk that the institution posed to the fund. In practice, developing complex risk-based premium matrices is quite difficult and we think promises to be quite time consuming.

    We believe it's more important to, again, as I said, get rid of the cliff for those 92 percent of the banks that currently are paying no premiums. They should start to pay some premium, a small premium that would remain constant over time to gradually build up the fund to some range that needs to be determined in lieu of the 1.25 DRR, but save for a later day, really extending dramatically the risk-based structure that we currently have. Because we just think, though again it sounds like a nice idea, in practice it could be quite complicated and bog down the urgency of other reforms.
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    Ms. WATERS. How would you calculate any premiums? How would you do that? How would you determine the premium for any given institution?

    Ms. BAIR. I think that's a difficult job. The FDIC sets out some criteria. It leaves several issues open. If you read Director Seidman's testimony, if you read Governor Meyer's testimony, they have a little different approach on some of these issues.

    Another problem, I think, is to come up with a matrix that would accurately assess risk for each institution, the spread among premiums that would accurately reflect risk may be so wide as to be politically impractical, and that is acknowledged in the FDIC study, that for some reason the premiums would be so high that they would cap it. The Fed may have a different view. That's just one of many issues, I think, which would need to be worked out if we're going to extend risk-based premiums, which is why we're saying hold that for a later time.

    Ms. WATERS. Mr. Meyer.

    Mr. MEYER. Thank you. We do support a risk-based pricing structure, and we recognize that it would be a challenging task, but we believe that the FDIC is pointed in a reasonable direction. They've identified three kinds of information that could be used to differentiate the risk across banks. One they call objective factors, the second, supervisory information, and the third, market signals.

    In objective factors, we could use such information as the amount of capital that the bank has relative to their assets, their net income relative to assets, because earnings are the first cushion if there are problems in the loan portfolio, the amount of non-performing loans relative to assets that indicate the risk exposure in the current portfolio, the amount of liquid assets relative to assets, because liquidity is also a very important factor in problems, and the degree of asset growth, because there is a correlation between very rapidly growing banking organizations and risks.
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    And then, in terms of market information, when available—and for the larger banks, this information is available—we have information coming from subordinated debt spreads and information that can be gleaned from equity prices about the probability of default for the bank.

    Now, this information can be used to separate the banks into risk class. Once you identify the different risk classes, you would use information the FDIC suggested on the historical pattern of losses within each group to identify the premiums that would just, on average, pay for those losses over, they suggested, a 5-year period.

    So I think this is a very reasonable methodology. I think it's a challenging one. I think it can be refined over time. But I think we have a good direction to move in here.

    Ms. WATERS. Thank you very much.

    I would also like to hear from Director Seidman on this question. But I'd also like to ask you to add a little something and discuss it in relationship to small banks. And if you use the general kind of criteria that was just described, would this not disadvantage small banks, small financial institutions?

    Ms. SEIDMAN. Could I add something about large banks first?

    Ms. WATERS. Yes, of course.
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    Ms. SEIDMAN. Let me just say that we not only have the example in the FDIC options paper, our neighbors to the North have done a rather good job of this. This does not have to be as enormously complicated, as Comptroller Hawke has said, as the Basel proposal.

    I would suggest that the concentration of activities is an area the Canadians take into account that is not mentioned in the FDIC matrix, and it's one that I would think would be quite important.

    Now, with respect to small versus large institutions, I'm not sure how it cuts precisely. I realize that there are certain issues like the extent to which small institutions, particularly small institutions down the midsection of the country, are fully lent up, that would make them come out worse on the FDIC's matrix. On the other hand, other small institutions, particularly on the coasts, have a tendency, in fact, to have very high amounts of deposits and less reliance on non-deposit funds and fewer problem assets, and things like that, than large institutions. So I'm not sure it's purely a small versus large issue. I think it's worth running the numbers and seeing how they come out and seeing whether when you do get the answer it looks right. That's always an important thing to do when you're doing detailed mathematical calculations.

    But the lending up problem, I think, is the one that everyone is focused on. It is a serious issue in the midsection of the country for small institutions, and I think it's worth taking a look at.

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    Ms. WATERS. Mr. Chairman, if I may just get another minute here. The S&L scandals have led us to understand what happens when institutions get away from the concentration of activities, kind of the terminology you used, their basic core activities. We're looking now at institutions that may be delving into all kinds of commercial activity. Doesn't this make it extremely difficult to do the kind of assessments to determine the risk that we would like to know about in order to develop pricing for the premiums?

    Ms. SEIDMAN. Because you mentioned the S&L situation, I guess I have to take the first answer here, but then I'm going to leave it to my colleagues to finish up. I think we're talking about concentration in two somewhat different ways. There's no doubt but that a significant portion of what happened at the beginning of the 1980s with respect to the S&Ls was that they went beyond what they had traditionally done.

    On the other hand, they went beyond what they had traditionally done in an era of a good deal less supervision, when they were trying to fight a very bad interest rate risk problem that was causing them to want to bet the farm in ways that they should never have been allowed to do. The ones that stuck to their knitting, that stuck to the residential mortgage lending that they had always done, in general, came through it. At least where they didn't have a massive real estate bubble to deal with, they came through it OK.

    However, some diversification of activities is definitely a good idea. A diversified portfolio, as Governor Meyer pointed out, is the traditional recommendation about how you reduce risk. It is important, however, to diversify into activities that you know how to do, and to do them well, and to monitor them thoroughly, and to make sure you have the systems that support them.
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    Chairman BACHUS. Thank you.

    Mr. Bereuter.

    Mr. BEREUTER. Thank you, Mr. Chairman. I'd like to, of course, add my welcome to the panel today. I think I must share some of the concerns the gentlelady from California has from her comments about small banks. It seems you agree that you don't like the statutory restrictions on premiums imposed in 1996. You're not interested in increasing the deposit coverage, and you want to merge the BIF and the SAIF. But I think, if I may say so, you're not very explicit about giving us a good rationale for doing those things.

    I also had the view that ''free rider'' is an interesting, and sort of negative, term to use, which might not be altogether appropriate.

    Governor Meyer, may I start with you and talk about your opposition to the 1996 statutory restrictions on premiums? As you know, in that legislation, which Congressman Vento and I had something to do with that limitation, you indicate the two variables—capital strength and examiner overall rating—do not capture all the risks that banks and thrifts could create for the insurer. The Board believes that FDIC should be free to establish risk categories based on well-researched economic variables and to impose premiums commensurate.

    But ''well-researched economic variables'' is a very vague term. I'm very hesitant to extract very large amounts of money out of the economy that is available for lending in our institutions. And I'm very concerned about keeping our commercial banks competitive with other kinds of financial institutions. Can you be a little more explicit in your opposition to the current 1996 Act's limitation on premiums?
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    Mr. MEYER. Maybe the way to think about this is to make a contrast with what Congress did in 1991, when it passed the Federal Deposit Insurance Corporation Improvement Act (FDICIA), and what it did in 1996, because in 1991, Congress passed a bill that mandated that the FDIC implement a risk-based structure of premiums.

    Now what's valuable about such a system is, it's more equitable, because then, safer banks are not subsidizing riskier banks as they are when everybody pays the same premium, and it avoids the problem with the zero premium giving away the Government guarantee. Everybody should pay an appropriate amount related to their risk for the insurance coverage.

    Mr. BEREUTER. Why should every bank pay some? The least risky, why should they?

    Mr. MEYER. Because every bank, no matter what their risk is, imposes some risk to the fund, and therefore should pay some premium. It should pay a lower premium when it imposes very little risk, and it should pay a higher premium when it imposes more risk, and it should pay a considerably higher premium when it imposes a considerably higher risk. That's the view.

    Now I understand the intent of the 1996 Act. The problem with FDICIA was that it set a designated reserve ratio, but then the question is, what happens if the fund rises above that reserve ratio? Should there be any limit to the fund?

    Mr. BEREUTER. We made the assessment, Mr. Governor, that when you have capital strength and you have examiner overall ratings that are very good, that these banks therefore do not impose a high risk on the insurance fund. And we're just basically saying this is a category. Yes, we can believe in risk assessment and properly adjusted premiums, but by these two measures, the risk is so small that these banks ought not be assessed a premium at all.
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    Mr. MEYER. That would be the view that there is no difference in the risk across those banks. We believe there is a difference in the risks across those banks. We believe even the safest banks impose some risk, and that's really what the issues are, I believe.

    Mr. BEREUTER. I'll move to Secretary Bair and ask with respect to deposit insurance coverage, you say: ''It is not surprising, therefore, that we found no evidence of consumers expressing concerns about the existing deposit insurance limits.'' And I would just suggest that's not the relevant factor. Consumers can find other places to take their deposits. What the concern is that we see, because of the limits which have not been adjusted for quite some period of time, can go back to one of two dates, appropriately, that they are finding other places for their money, typically outside the community where the deposits are generated. At least that's the experience in my own State.

    And whether consumers can find a place or not is not really the relevant question. The relevant question is, is it inappropriate to adjust the levels so that these commercial banks can be competitive with other financial services institutions and whether or not you are in the process by not adjusting the limit, forcing money out of those communities that should be available for lending in those communities?

    And relatedly, I would ask you your views on whether or not there should be some change in requirements with respect to municipal or other political subdivision deposits, because that is particularly sensitive to small communities when they see that those funds are necessarily leaving the community when there is perhaps only one or two commercial banks in that particular community or region.
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    Ms. BAIR. There are many components to your question. One consistent theme in your question is the thought that funds are flowing out of community banks, because of the coverage limit, and I guess that's where we'll have to agree to disagree. We don't see evidence that that's the case that the coverage limit has anything to do with it. To the extent that it's happening, higher yields may be driving that dynamic.

    Number two is, as the Fed points out in its testimony and Governor Meyer in his oral statement as well, small banks are highly competitive right now. They are getting insured deposits and uninsured deposits. The number of uninsured depositors is only 2 percent of the universe of depositors, so presumably it's only those 2 percent that would benefit immediately from a rise in the coverage limit. Those people—they are higher income folks, there is no evidence that they are concerned that some measure of their deposits in federally-regulated banks is uninsured. To the extent we're dealing with those 2 percent, you're dealing with the higher income levels. The income level for that 2 percent is double the median income for those whose deposits are completely insured by the $100,000 limit.

    Again, to the extent people are uncomfortable with having uninsured deposits, there are so many ways to address this. You can go to multiple banks. You can open up multiple accounts in different legal capacities at the same bank.

    For all those reasons, Congressman, we just don't see a clear case has presented that this is going to help. I will say our door is open. We are happy to discuss this. I'm happy to discuss this further with you. Any additional data you may have, I'm happy to take a look at. But based on what has been presented to us at this point, we just don't see a convincing case has been made.
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    Mr. BEREUTER. Mr. Chairman, I know my time has expired. But I would just say the experience I have in visiting with the bankers in my district and to consumers and to depositors is not the same that you suggest. These consumers, these depositors are very smart, and they're taking their money out, and they're very risk-averse. And so if it's not covered beyond $100,000, they're taking it outside the area.

    Chairman BACHUS. We appreciate that, Mr. Bereuter.

    Mrs. Maloney.

    Mrs. MALONEY. I thank you, Mr. Chairman, and thank all of the panelists for joining the subcommittee today. I particularly want to mention Ellen Seidman's fine service to the country. This will probably be our last opportunity to hear your testimony. Personally, I regret that you are not allowed to fulfill your entire term. But believe me, we all appreciate your fine service.

    I believe ensuring the future safety and soundness of the banking system and the health of the insurance funds is the most important responsibility of this subcommittee. And I deeply believe that we all owe outgoing FDIC Chairwoman Tanoue a debt for beginning the debate on deposit insurance reform.

    I am, however, concerned that the FDIC proposal would lead to additional premiums on banks. Any additional premium, we all know, would have a direct impact on the amount of loans that institutions can make in all of our communities. Given the relative health of the banking industry and the prospect of a strengthened merged insurance fund, why should Congress consider raising deposit insurance premiums? I'd just like to ask all the panelists.
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    Mr. MEYER. I think we have indicated that we think that insurance should not be priced at zero. Every bank poses a risk, riskier banks pose more risks. Every bank should pay for its insurance in relationship to the amount of risk that it implies for the fund.

    Now I think all industries would appreciate being subsidized, and all industries would be larger if they're subsidized. But we think that it is more equitable and it is more efficient that banks pay for insurance according to risk and that that behavior is a factor that helps to control the risk-taking of those institutions. If you support and want a safe and sound banking system, a risk-based structure of the premiums is a very important component of a program that supports that safety and soundness.

    Mrs. MALONEY. Would you like to comment? Go right ahead.

    Ms. BAIR. I would just say, to me the question is not so much whether, but when, they will have to pay. I think now you have a situation where 92 percent of all banks pay no premiums. But, as the Chairman pointed out in his opening remarks and his later follow-up questions, if we fall below that 1.25 percent, and it looks like we're going to be there beyond a year, there's going to be a 23 basis point cliff that's going to hit all banks square in the face, and at that point, they are going to be paying. You're going to be taking significant amounts of capital out of those banks and sending it to Washington to replenish the fund.

    We believe that system should be replaced with a system where you have a wide range as opposed to a DRR, small basis point premiums for all banks, gradually build up the fund to whatever that higher range should be with a system of rebates once you pass that higher range. And through that you will ease out the potential volatilities that you have with the current system where you go from paying no premiums to paying a really whopping sum.
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    So I don't think it's a question of whether. I would like to say the fund is never going to fall below 1.25, but we all realistically know that we're running a danger here, and I think the question is whether we want a system where you have a cliff or whether you have a smoothing out of premiums over time.

    Mrs. MALONEY. Thank you.

    Mr. Hawke, in your testimony you have this report on reforming the funding of bank supervision. And you've mentioned in your testimony, and you've mentioned to me and others, your concern about the disparity in the cost of bank regulation between the State and national banks. Could you comment on the impact this has had on the State and national charters and on deposit insurance reform?

    And I must say that a number of colleagues and professionals in the industry have mentioned that reforming the funding of bank supervision should not be part of this debate or this particular bill. And if you believe it should be part of this debate and this particular bill, why do you believe it should be part of it?

    Mr. HAWKE. Thank you, Congresswoman Maloney, for allowing me to address that issue.

    First of all, the basic problem is that there is a very significant disparity in what State and national banks pay today. The average $500-million national bank will pay about $113,000 in assessments, while a comparably sized State-chartered bank in an average State that has strong supervision would pay only $43,000. That presents a constant incentive for national banks to consider converting to a State charter, and we see it all the time.
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    We calculate that over the last year-and-a-half or two years, about $60 billion in assets have left the national banking system for State charters, motivated solely, or virtually entirely, by that cost saving. And that cost saving is attributable only to the fact that the FDIC and the Federal Reserve absorbed the cost of their supervision of State-chartered banks while national banks have to pay the entire cost. Only a fraction of the cost of State bank supervision is recovered from State banks, whereas virtually the entire cost of national bank supervision is recovered directly from national banks.

    We think this is an issue that's integrally related to deposit insurance reform for a couple of reasons. First, it relates to what the optimum size of the fund should be. You can't, it seems to me, consider what the size of the fund should be without taking into account the fact that, at the present time, the FDIC takes about $600 million a year out of the fund to cover the cost of its supervision of State-chartered banks. That has a direct relationship to what the size of the fund is or should be.

    Second, it relates to rebates. Today, national banks, in effect, pay 55 cents of every dollar that the FDIC spends on State bank supervision. If there are going to be refunds or rebates from the fund, we think that the inequity of national banks contributing to the cost of State bank supervision should be addressed; national banks should get rebates that make them whole, in effect, for their contribution to the subsidization of State-chartered banks, before rebates are paid to other banks.

    So I think these are issues that are integrally related to deposit insurance reform. One of the general principles underlying deposit insurance reform is eliminating some of the cross subsidies that exist today in the deposit insurance system, and this inequity in funding is clearly in that category.
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    Mrs. MALONEY. My time is up. Thank you, Mr. Chairman.

    Chairman BACHUS. Ms. Hart.

    Ms. HART. Thank you, Mr. Chairman.

    My first question actually is for the Assistant Secretary, Ms. Bair. In the testimony that you gave, you questioned whether or not the Federal Home Loan Bank advances should have priority over other bank liabilities in the event of a failure of a bank. Do you recommend that the subcommittee should change this? And if so, in what way? Should we prioritize differently or do something else that you might suggest?

    Ms. BAIR. I don't think we suggest that the priorities should be eliminated. What we suggest is that those advances should be included in the assessment base so that they're reflected in the premiums that are charged the depository institution.

    Ms. HART. So the current priorities, as far as you're concerned——

    Ms. BAIR. Well, as you know, the fact that the Federal Home Loan Banks have a priority claim over a bank's assets over the FDIC, then to the extent a bank increasingly relies on advances from the Federal Home Loan Bank in lieu of insured deposits, it is increasing risk to the fund.

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    So we think some consideration should be made as to whether you include those advances in the assessment base that's used to calculate premiums, whereas now it's just insured deposits.

    Ms. HART. OK. And this is just for the panel in general, actually especially probably for Treasury and maybe the Fed. We had an earlier hearing on the issue of Gramm-Leach-Bliley's opening up the financial services market and perhaps allowing banks to be involved in real estate brokerages. In light of that change, if you would see that as it seemed that day of the hearing, which is basically it should be wide open, would you think that there should be some change regarding FDIC and coverages or any other thing in the market that would change, because of that pretty significant, as I would see it, change in the responsibilities of those institutions?

    Mr. MEYER. I wouldn't see any necessary change there. We are talking about an agency activity, which in our view would be a relatively low-risk activity. So I wouldn't see that that would have any implications for Federal deposit reform.

    Ms. BAIR. I have nothing to add to that other than I was just sworn in as the new Assistant Secretary for Financial Institutions at six o'clock last night in my new office, where there are stacks of boxes containing 32,000 letters on that particular rule proposal. So assuming it's going to take me a while to filter through those, obviously I can't comment on the rule, because it's pending, but certainly it's an agency activity, so at least on that particular issue, I wouldn't see that it would impose excess risks.

    Ms. HART. One more just sort of to clarify a little bit. I understand it's not necessarily just an agency activity, however. It goes beyond that. Would it not give them also the power of management and other powers that I know some of them are currently involved in and would be actually responsible for in the liability arena?
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    Mr. MEYER. Well, management, but not the ownership of the assets. And the real risks come when you own assets whose value is variable and where you're subject to loss. So, again, I don't think that either of those activities would involve the kinds of risks that would make a material difference in the assessment of what the overall size of the fund should be or what the risk-based premium should be.

    Ms. HART. Does anybody else on the panel have an opinion on that one? Sure.

    Mr. HAWKE. I would just add that one of the objectives of bank supervision today is to try to help banks diversify the sources of their revenue. Banks have traditionally been very heavily dependent on net interest spreads as their source of revenue. One of the motivating features behind Gramm-Leach-Bliley was to help diversify revenue streams within the area of financial and financially-related activities, to the extent that that can be done in a safe and sound way. We think an agency activity that doesn't present risk to the bank, but helps diversify the bank's income stream works toward the reduction of overall risk.

    Ms. HART. Anybody else? OK. Thank you. I yield back my time, Mr. Chairman.

    Chairman BACHUS. Thank you.

    Mr. Watt.

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    Mr. WATT. Thank you, Mr. Chairman.

    Chairman BACHUS. You get an extra 20 seconds of her time.

    Mr. WATT. I appreciate that very much. There seems to be a substantial amount of agreement in your testimony, and I want to go to one area where there, I guess, potentially is some disagreement, and that's this question of how you fund supervision. I know Mr. Hawke's opinion on that. I have not heard Mr. Meyer express any opinion on it. And I'm wondering whether you have an opinion on it and if you would care to share it?

    Mr. MEYER. Thank you. I think that Comptroller Hawke has made a very good case that there are problems associated with the current funding arrangements for bank supervision specifically affecting the OCC and the OTS. And I think there are two elements here. The first is the funding arrangements where the funds depend upon examination fees that come from your assessment base. That funding is potentially unstable, because it depends upon charter choice decisions. And second, there's a disparity across the various banking agencies in terms of how supervision is funded.

    Having said that, our view would be that, notwithstanding the fact that there's some relation to the FDIC fund, it would be a mistake to try to tackle this issue as part of deposit reform. And the reason for that is that we have reservations about the specific solution. We agree that there is a problem. We agree that we ought to work to resolve that problem, but we have reservations about the particular solution that the Comptroller has suggested.

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    Mr. WATT. OK. I got that. Let me put a slightly different spin on this since we're at the very beginning stage of starting to talk about a solution to this disparity and maybe make a slightly different view about this.

    It seems to me that one can make the argument that the deposit insurance fund is about premiums for insuring the $100,000 of deposits that we are, in fact, insuring. The question of supervision of banks is a separate issue which—and it seems to me, if we are taking the general supervision cost out of the fund, the insurance fund, which is designed to pay for losses up to $100,000, basically you have lower income, lower amount depositors paying the full cost of supervision for banks and higher income people and other activities that really have nothing to do with the insurance fund.

    So one approach to this might be to take all of the supervision out, both your supervision and the national banks' supervision, and to create a separate supervision fund so that lower-level depositors, people who are depositing $100,000 or less, are not really paying the cost of the overall supervision of everything that the bank is doing.

    Now maybe I could get your preliminary reaction. I know this is kind of a radical theory. But maybe you could give me your preliminary reactions to that. And then I'd like to hear from Mr. Hawke on the same question and Ms. Seidman on the same question.

    Mr. MEYER. First of all, our supervision costs are not paid out of the FDIC fund. They're paid from our earnings on our portfolio of securities.

    But second, that approach still encounters the following problem: You have to come up with a mechanism for funding. If that mechanism is Federal funding——
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    Mr. WATT. But it's not on the backs of $100,000-or-less depositors.

    Mr. MEYER. Right. That's fair. But you have to come up with a mechanism, and you have to deal with—if it is going to be Federal financing—can you maintain the viability of the dual banking system and have Federal financing of State examinations?

    Mr. WATT. Mr. Hawke.

    Mr. HAWKE. Mr. Watt, the most straightforward way of dealing with this problem would, of course, be for the Federal Reserve and the FDIC to impose assessments for the cost of their supervision, just as we do with national banks. National banks pay us the entire cost of their supervision. State-chartered banks only pay assessments to their State regulators, which really accounts for only a small portion of the cost of their supervision. The predominant component of the supervision of State-chartered banks comes from the FDIC and the Fed.

    So the problem is created by the fact that State-chartered banks are not charged by their Federal supervisors. Year after year, OMB has sent to the Hill a proposal to require the Fed and the FDIC to charge assessments for their supervision, but that's basically been dead on arrival.

    Mr. WATT. So what you're saying is actually consistent with what I'm saying?
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    Mr. HAWKE. Yes. The most desirable way to do it doesn't seem to be politically feasible.

    Mr. WATT. Ms. Seidman.

    Ms. SEIDMAN. It is an intriguing proposal. I would like to point out that currently, $600 million a year is taken out of the insurance funds to supervise State non-member banks. So currently, we have exactly the situation that you're talking about. It's just that we only have it with respect to one kind of charter.

    Mr. WATT. Mr. Meyer said that wasn't the case, though.

    Ms. SEIDMAN. It isn't for the Fed. It is for the FDIC. The Fed just takes it out of, in essence, general revenues. Now the issue of whether supervision is related to insurance is one that, I think, is critical.

    Mr. WATT. I acknowledge that there is some relation—don't get me wrong. I know there is some relation—supervision of the insurance costs something, but it doesn't cost the whole insurance package is the point I'm making.

    Ms. SEIDMAN. And that's why I think that as long as we're putting alternatives on the table, you'll notice that in my testimony there's another alternative, which is, in essence, that as soon as we get banks that get into trouble, 3-rated banks and lower, that at that point, all the supervisory costs should come out of the insurance fund. Because there you can say we are really running a risk here. We're running an insurance risk that is really immediately quantifiable in a much bigger way than the risk of 1- and 2-rated banks, as to which the risk is more attenuated. I support the notion that insurance should not be free. But we're talking about 1 basis point premium ideas for top-rated banks. When you get to 3- and 4- and 5-rated institutions, you're talking about a much more immediate kind of risk.
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    And I will tell you as a bank supervisor, our job is to keep those banks out of the insurance fund.

    Mr. WATT. Thank you, Mr. Chairman.

    Chairman BACHUS. Mr. Tiberi.

    Mr. TIBERI. A quick question for the Assistant Secretary. On page 4 of your testimony, you suggest that we examine the assessment base for the payment of deposit insurance premiums. Could you explain what you mean and give us suggestions?

    Ms. BAIR. That was mainly a reference to Congresswoman Hart's earlier question about the increasing reliance that some banks are placing on secured liabilities and also, because Gramm-Leach-Bliley gave community banks the ability to get advances from the Federal Home Loan Banks, regardless of whether they're using the money for any activity, not just home mortgage financing. Because the secured liabilities take precedence, take priority over the FDIC's claims in the case of a bank failure, they're posing additional risk to the fund.

    So the question is whether the secured liability should be included in the assessment base, which would, by broadening the assessment base, also increase the premium for the particular institution.

[The following information was provided at a later time by Hon. Sheila Bair:
[As a matter of clarification, a broader assessment base may be accompanied by lower premium rates to achieve the desired revenue for FDIC. Thus, a bank's premium may or may not rise with a change in the base.]
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    Chairman BACHUS. All right. Thank you. Let me ask this question. We're just going to keep going and hope that people come back. You had a lot of questions about the small community banks. And the concern is that they will be able to generate deposits. One source of funding has been the Federal Home Loan Bank. Assistant Secretary Bair, you mentioned that funding from that source may create a special risk or reliance on that funding they have a preference in case of a failure. At the same time, where do they go to generate deposits or funding? And that is one of the places they're going. But where do they go for growth?

    And I would like you to—maybe all of you ought to consider—and the small banks are telling us in this equation that they want an increase in deposit insurance. That is where they feel like the growth can be.

    Two other areas that they've suggested to us are municipal deposits and IRA or retirement accounts. Now let me say on municipal deposits that I don't think that's just speculation on their part. What we're talking about, and Governor Meyer, you talked about the whole universe of smaller or newer institutions, some of these institutions are in big cities. But when we talk about the institutions in the small towns, I doubt if you took those out of the universe that you came up with the growth of 12 or 13 percent, I'm not sure that that would be true. Because I think when you have a rural county with one hometown bank or one bank in the county, or in the county seat, that those banks are not tending to grow.

    This is a long question, but you can have a long answer. One possible suggestion concerns municipal deposits, because of the collateral requirement. And I can tell you that school boards, county school boards, city governments are saying we would like to do business with our only hometown bank, but we really are limited by insurance coverage. The State of Massachusetts, particularly, has a State program where they can buy additional insurance to cover municipal deposits. And I don't know whether it's just to increase their coverage. I'd just like your comments on what we could do to benefit these banks.
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    Mr. MEYER. I think the first thing to do is let's not try to solve a problem that doesn't exist. You focus on an important area that many people are talking about of whether small banks are under competitive pressure and they can't fund their assets. So let's look at some of the facts: 1995 to 2000, insured deposit growth, how fast was it? 9.6 percent a year. Let's compare that to the largest banks. These are the small banks, 1,000 and below, OK? These are relatively small institutions. The 100 largest banks had average deposit growth of less than one-half a percentage point.

    Chairman BACHUS. Let me interrupt you and just ask you, did you break that out into rural banks?

    Mr. MEYER. I didn't. These are small banks. We could look further at that. But if you say that there's a problem, what's the problem? Their insured deposits were growing at 9.6 percent, but their assets were growing at 13 percent, OK? That's more than twice as fast, or about twice as fast, as larger banks were growing adjusted for mergers.

    So the problem—and we don't think this is a problem—is that small banks are growing very rapidly, and they're not able to fund all of that rapid growth from insured deposits. So what are they doing? That's the legitimate question. Well, they're funding a lot of it from uninsured deposits. How fast were they growing? At a 20.5 percent annual rate, again, twice as fast as they were growing at large banks.

    So now, the final analysis is that these small banks were funding almost 85 percent of their assets from their deposits, insured and uninsured deposits. But their amount of funding from total deposits did go down a little bit, 2 percentage points over this period, and that was made up by Federal Home Loan Bank advances. That's what filled the gap.
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    Chairman BACHUS. All right.

    Mr. MEYER. But, we just don't see that there's a problem to be solved here.

    Chairman BACHUS. All right. I understand. Now you would be willing maybe to revisit that and see whether we're talking about urban institutions or——

    Mr. MEYER. It's a very good question, and I'll see what we can do to come up with some data there.

    Chairman BACHUS. Madam Assistant Secretary.

    Ms. BAIR. Well, we consider our primary role in this debate is the advocate of the taxpayer and I guess the concomitant to that is, you know, we want to minimize the risk exposure of the fund, because ultimately, that is the best way to represent the taxpayers' interest on this issue.

    So we go into the question of whether you should raise coverage limits with deep skepticism. However, if there's additional evidence to be presented that would show that there would be a competitive benefit, or a benefit to consumers pointing to the various proposals that have been on the table, we're willing to look at it.

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    On the specific question of whether to provide 100 percent insurance for municipal deposits, I think that also raises some other policy issues that need to be considered. One is, I think, it kind of goes to what's the core purpose of deposit insurance? Is it to protect small depositors, or are we going to broaden that to specified categories that go beyond the traditional small depositors which the system was designed to protect?

    Second of all, I think there's an issue as to if you provide 100 percent coverage, do you decrease incentives on the part of municipal officials to make sure that the institution where they're putting the taxpayers' money is a safe institution? So I think those are two things that need to be considered.

    That said, we are deeply skeptical, but if there's data or evidence, we'd be interested to know what the rural bank breakout on the statistics is that this would help consumers or improve competition. But we're open to hearing those arguments. But right now, we just have not heard them.

    Chairman BACHUS. Yes. And let me say this. When we're talking about municipal deposits or governmental deposits, what in my mind we're also talking about, at least I can't express the sense of the Congress, but public policy behind a county government or a city government being able to keep more than $100,000 worth of their deposits in a local-based financial institution. I think there is a certain public policy argument that that option ought to be open to them. If we can create—and I'm not talking about unlimited. Obviously I understand moral hazard. I'm not talking about uninsured. But if we can create an insurance fund for municipal deposits of some amount, and whether we're talking about half-a-million, or a million, but I would at least like us to look at that, particularly in that the small banks—and what you've proposed also is that we look at part of the risk basis, how much they rely on the Federal Home Loan Bank, and obviously, we're going to probably find that the small banks may be impacted by that, although I don't know.
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    But I would approach it from a public policy standpoint and see what remedy could be fashioned.

    Ms. BAIR. That suggestion extends to all secured liabilities. Federal Home Loan Bank advances were given as an example because it is a recent change. But we're talking about all secured liabilities.

    Chairman BACHUS. OK.

    Mr. HAWKE. Mr. Chairman, we regulate more than 2,200 community banks, so we have a very strong interest in the welfare of community banks. And I must say that as our community bankers come through and visit with us, for every community banker who thinks he or she would be advantaged by raising deposit insurance limits, there's another one who thinks that it might be disadvantageous. I don't think anybody really knows with certainty what the consequences would be for community banks of a significant increase in deposit insurance limits. It may simply result in a very disruptive shuffling of deposits among banks with no net winners or losers.

    One of the facts that affects my thinking about this is that today there are more than $2 trillion invested in money market mutual funds, and over $1 trillion in uninsured deposits in banks. That suggests that people who have liquidity and wealth to put out in reasonably safe investments are not being highly motivated by deposit insurance. Today, with a minimum of inconvenience, anybody who wants to maximize deposit insurance coverage can do so by going to multiple institutions or multiplying accounts within a single institution.
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    But there's so much uninsured liquidity outside the banking system today that I think one has to be skeptical about what the consequences would be of increasing coverage limits in terms of bringing new deposits into the system.

    Chairman BACHUS. Even your proposal that we balance the examination fee, I think, will result in more smaller banks or State-chartered in these communities. So we're again talking about a thing——

    Mr. HAWKE. Our proposal would be a significant benefit for State-chartered banks. It would relieve them of the burden of having to pay assessments to their State supervisor. Today, State-chartered banks pay roughly $160 million in assessments to their State supervisors throughout the country. Our proposal would shift that expense to the FDIC fund. So it would result in significant benefits to State-chartered banks, as well as relieving the inequity for national banks.

    Chairman BACHUS. And that would probably be the smaller banks you think would benefit?

    Mr. HAWKE. Any State-chartered bank that's paying assessments today—and they all pay assessments to their States—would be relieved of that burden.

    Chairman BACHUS. Let me ask you one final question. Is there any policy prescription that you could offer the subcommittee that might address—and I know, Governor Meyer, you're saying there aren't any liquidity problems with the small banks—but with the smaller banks? Can you offer any possible solutions or proposals which might help them raise deposits?
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    Mr. HAWKE. I think, Mr. Chairman, that there's room for the market to work here. Today, the $2 trillion in money market mutual funds suggests that people who have wealth to put out to work don't see a significant difference in the risk characteristics between banks and money market mutual funds and are willing to take whatever that risk differential is to get the higher yield. So, I think, as Assistant Secretary Bair suggested, this may really be a question of yield.

    Ms. SEIDMAN. May I also suggest something else? Your questions have been focused on the liability side of the balance sheet—on deposits and Federal Home Loan Bank advances. The bigger question, I think, that all small institutions, and particularly small institutions in relatively small communities face, how to fund loans in general. I go out there and see this happening with respect to home loans for some of the smaller rural thrifts. That is the big question. How do I fund these loans? And so I think to some extent one of the issues that we all ought to be working on is whether there are techniques that some of these very traditional smaller institutions can begin to use that some of the bigger ones have been using to make it possible to fund more lending activity with less on the liability side.

    Now I'm not suggesting that all of them should get into massive asset securitization, or should all go into commercial and industrial loan syndications. But we work a lot putting together consortia of small institutions to participate in larger multifamily lending, or even in some of the riskier kinds of single-family lending. There are opportunities to do things like that.

    That's not as quick and widespread a solution as raising the deposit insurance level seems to be, but I will say that one of my real concerns about whether raising the deposit insurance level could possibly be as effective as some of the institutions think it is—and certainly some of the institutions we regulate have said this to me—if you don't fix the problem of multiple accounts in multiple banks, there's no particular reason to believe that raising the level will benefit the community banks more than it will benefit the larger banks. And in fact, it might lead to some further consolidation away from the smaller banks.
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    Chairman BACHUS. Governor Meyer.

    Mr. MEYER. Mr. Chairman, I think there is one thing that the Congress could do that would benefit small banks, and that is to allow the payment of interest on demand deposits. As you know, this is an issue that affects small banks relative to the larger banks, because the larger banks have found a way to in effect pay interest on demand deposits through sweeps. Allowing small banks to pay interest on demand deposits would make them more competitive not only with larger banks, but also with non-bank financial institutions.

    So as you think about this problem and keep in mind the health of our small banks in this country, I think that's very much something that would be a benefit to the broader economy, but also would accrue specifically and especially to smaller banks.

    Chairman BACHUS. And, that measure has passed the House and is awaiting action in the Senate.

    Mr. MEYER. I appreciate that.

    Chairman BACHUS. I would——

    Ms. BAIR. Mr. Chairman, if you don't mind, if I could add one thing? I would come full circle to where you started this hearing, which is the 23 basis point cliff. I think getting rid of that—I think that, in particular, is a tremendous threat to smaller banks, and replacing that with some type of system where you have a smoothed out system of premiums would be tremendously helpful.
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    I also want to clarify, after going back and reading the written testimony on this Federal Home Loan Bank advance question, I don't want anyone to think that the Treasury is suggesting that we don't think a bank should have Federal Home Loan Bank advances as a source of capital. We do. We just note it in context of other secured liabilities.

    Chairman BACHUS. I didn't see any suggestion that you did.

    Ms. BAIR. OK, good. Treasury has long had the position—the previous Administration had urged Congress in the context of insurance reform to take a look at the whole question of what should be in the assessment base and how you treat secured liabilities in the assessment base.

    Chairman BACHUS. One comment I would add to your comment. And I think all of you have more or less said that raising the insured amount of deposits might not help small banks. But the small banks are telling the Members of Congress where those banks reside that it would help them. So we have the regulators saying it wouldn't help them, but we have the people that own the banks and operating them telling us that it would help them.

    Mr. MEYER. Mr. Chairman, if you price insurance at zero, I think banks are going to want the most that they can get, and I don't blame them.

    [Laughter.]

    Chairman BACHUS. Thank you. Maybe we ought to quit on that.
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    [Laughter.]

    Chairman BACHUS. I'm not sure that I want to adjourn the hearing. I was hoping Members might come back.

    [Pause.]

    We very much appreciate your testimony today. I would ask that this be a continuing process, that we continue to meet informally, continue to try to build a consensus.

    One thing that we all agree is that the Federal deposit insurance system needs to be reformed, and there is a consensus around certain measures. My caution would be—and sometimes there are Members of Congress that are saying to you, ''address this limited issue''—but let me give you some inconsistent advice with that.

    We don't want to overcomplicate any regulatory scheme, because no bank or no institution is going to benefit from a complicated formula, one that's hard to interpret and has tremendous discretion, which they will all assume works to their disfavor.

    Mr. HAWKE. Mr. Chairman, wait until you see the Basel proposal.

    [Laughter.]

    Chairman BACHUS. I think that is why we ought to keep it as simple as we can. Keep it as workable as we can without additional paperwork and requesting all sorts of information that we don't presently request and actually end up stepping up the regulation above what needs to be done.
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    We will leave the record open for 30 days to allow Members to submit questions for the record and appreciate your testimony. The hearing is adjourned.

    [Whereupon, at 11:50 a.m., the hearing was adjourned.]