Response to Questions Relating to H.R. 3717, Federal Deposit	 
Insurance Reform Act of 2002 (16-APR-02, GAO-02-647R).		 
                                                                 
The Federal Deposit Insurance Reform Act of 2002 would change the
definition of the reserve ratio for the deposit insurance fund	 
and provide the Federal Deposit Insurance Corporation (FDIC) with
the flexibility to set the fund's designated reserve ratio within
a range. Current law requires FDIC to maintain the deposit	 
insurance fund balances at a reserve ratio of at least 1.25	 
percent of estimated insurance deposits. If the reserve ratio	 
falls below that level, FDIC's Board of Directors must set	 
semiannual assessment rates that are sufficient to increase the  
reserve ratio to the designated reserve ratio within a year, or  
in accordance with a recapitalization schedule of 15 years or	 
less.								 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-647R					        
    ACCNO:   A03085						        
  TITLE:     Response to Questions Relating to H.R. 3717, Federal     
Deposit Insurance Reform Act of 2002				 
     DATE:   04/16/2002 
  SUBJECT:   Deposit funds					 
	     Funds management					 
	     Proposed legislation				 
	     Bank Insurance Fund				 
	     Savings Association Insurance Fund 		 

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GAO-02-647R
     
GAO- 02- 647R Responses to Questions on H. R. 3717

United States General Accounting Office Washington, DC 20548

April 16, 2002 The Honorable John J. LaFalce Ranking Minority Member
Committee on Financial Services House of Representatives

Subject: Responses to Questions Relating to H. R. 3717, Federal Deposit
Insurance Reform Act of 2002

Dear Mr. LaFalce: This letter responds to your April 9, 2002, request that
we answer questions relating to H. R 3717, the Federal Deposit Insurance
Reform Act of 2002. Among other things, H. R. 3717 proposes changes to the
definition of the reserve ratio for the deposit insurance fund, as well as
provides the Federal Deposit Insurance Corporation (FDIC) with the
flexibility to set the fund?s designated reserve ratio within a range.

Current law requires FDIC to maintain the deposit insurance fund balances
(net worth) at a designated reserve ratio of at least 1.25 percent of
estimated insured deposits. If the reserve ratio falls below 1.25 percent of
estimated insured deposits, FDIC?s Board of Directors is required to set
semiannual assessment rates that are sufficient to increase the reserve
ratio to the designated reserve ratio not later than 1 year after such rates
are set, or in accordance with a recapitalization schedule of 15 years or
less.

Your questions, along with our responses, follow.

1. Sections 7( l)( 6) and 7( l)( 7) of the Federal Deposit Insurance Act,
which define, respectively, the Bank Insurance Fund Reserve Ratio and the
Savings Association Insurance Fund Reserve Ratio, as "the ratio of the net
worth of the [fund] to the value of the aggregate estimated insured deposits
held in all [fund] members.? What does the term net worth mean with respect
to the deposit insurance funds? In particular, is the reserve for
anticipated failures a liability that is to be deducted from the fund?s
assets to arrive at net worth for purposes of calculating the ratio?

Currently, FDIC?s net worth as defined by U. S. Generally Accepted
Accounting Principles (GAAP) is the same as the net worth used for the
reserve ratio calculation. Both the Bank Insurance Fund (BIF) and the
Savings Association Insurance Fund (SAIF) calculate net worth as the
difference between total assets and total liabilities. BIF?s and SAIF?s net
worth is called ?Fund Balance? on each fund?s annual audited

GAO- 02- 647R Responses to Questions on H. R. 3717 Page 2 Statement of
Financial Position that is prepared in accordance with GAAP. Included

in total liabilities for both funds are any estimated liabilities for
anticipated failures of insured institutions. Because the Federal Deposit
Insurance Act currently calls for using net worth when calculating the
reserve ratio, all liabilities, including the liability for anticipated
failures, are deducted from the assets to arrive at net worth for
calculating the reserve ratio.

2. H. R. 3717 as reported out of the Sub- Committee on Financial
Institutions would change the definition of the reserve ratio to add the
reserve for anticipated failures into the numerator of the reserve ratio
calculation. While the bill would also provide the FDIC with the flexibility
to set the Designated Reserve Ratio (DRR) in a range, (i) the DRR may not be
set higher than 1.4; and (ii) the FDIC is required to rebate one- half of
assessments when the reserve ratio reaches 1.35 and all assessments and
income in excess of the DRR when the reserve ratio reaches 1.4.

A. Would the reserve ratio as proposed to be revised in HR 3717 provide the
best representation of the information available about the fund?s true
financial condition?

Per H. R. 3717, any estimated liabilities for anticipated failures for BIF
or SAIF would be added back to fund balance for purposes of calculating the
reserve ratio. Therefore, the proposed definition of reserve ratio would not
include the liabilities for estimated losses that FDIC has determined are
probable to occur and are also estimable. To the extent that estimated
liabilities for future failures exist and are not considered for the
purposes of calculating the reserve ratio, the reserve ratio would not
provide the best representation of the information available on the fund?s
financial condition.

B. If the reserve ratio calculation were changed as proposed in HR 3717, how
would the calculation be affected as anticipated failures increased? Would
the reserve ratio become a more or less accurate reflection of the fund's
true financial condition? What would be the impact on the fund if the
reserve ratio reached 1.4 at the same time the FDIC had determined that the
financial condition of the banking industry made a large reserve for
anticipated failures appropriate?

Under H. R. 3717, changes in the estimated liability for anticipated
failures would have no impact on the reserve ratio. To the extent that
estimated liabilities for future failures exist and are not considered for
the purposes of calculating the reserve ratio, the reserve ratio would not
provide the best representation of the information available on the fund?s
financial condition and would result in a higher reserve ratio than under
current law.

Also, under the current law the numerator of the reserve ratio is the fund
balance, which is a widely understood measure of net worth. By adding back
any estimated

GAO- 02- 647R Responses to Questions on H. R. 3717 Page 3 liability for
anticipated failures to net worth in the calculation of the reserve ratio,
the

numerator will no longer represent the fund?s net worth, and the resulting
reserve ratio may not be as readily understood as the currently defined
ratio.

Under H. R. 3717, a scenario could occur where the reserve ratio is at or
exceeds 1.4 percent and FDIC has also recorded a large amount of estimated
liabilities for anticipated failures. FDIC would be required to declare
dividends and refund, in the form of dividends, the amount of excess fund
balance over the amount of the designated reserve ratio. In this scenario,
FDIC would be required to provide dividends even though it expects the
reserve ratio to decline in the upcoming year when the anticipated failures
are expected. This could result in FDIC refunding a portion of its fund
balance in the form of dividends at a time when funds are needed to cover
expected losses.

Similarly, under H. R. 3717, if the reserve ratio is at 1.35 percent and
there are also large amounts of estimated liabilities for anticipated
failures, FDIC would be required to declare dividends in an amount equal to
50 percent of the insurance premium income for that assessment period. In
this scenario, FDIC would be required to reduce its insurance premium
income, even when it expects the reserve ratio to decline in the upcoming
year when the anticipated failures are expected. This could result in FDIC
refunding premiums in the form of dividends at a time when premium income is
needed by the insurance fund to cover expected losses.

Finally, under the current proposal, it appears that a potentially anomalous
scenario could occur in the instance where FDIC sets the designated reserve
ratio at 1.4 percent and the actual reserve ratio is between 1.35 and 1.4
percent. In this case, it appears that FDIC would be required to declare
dividends in the amount of 50 percent of insurance premiums for that period,
even though the fund?s reserve ratio is still below the designated reserve
ratio.

C. What would be the impact on the timing of premium requirements if the
fund sustained large losses? That is, would the premiums have to be paid
after- the- fact, when the system is by definition weak, rather than being
paid when the system is stronger to build up the reserve?

The impact of adding back the estimated liabilities for future failures to
net worth in the calculation of the reserve ratio would have the effect of
delaying premiums in the case where the estimated liability figure would
have caused the reserve ratio to be below the designated reserve ratio.
Delaying premiums creates the potential for volatility in the payment of
premiums, possibly resulting in the banking industry paying high premiums
when both banks and the economy can least afford it.

FDIC may be able to mitigate the delaying of premiums described above
because under H. R. 3717 FDIC would have the flexibility to increase the
designated reserve ratio up to 1.4 percent. Therefore, FDIC?s decision on
setting the designated reserve ratio higher could result in not having
premium delays that otherwise would occur with a lower designated reserve
ratio.

GAO- 02- 647R Responses to Questions on H. R. 3717 Page 4

3. Some have stated that the reserve for anticipated failures should be
added to the numerator in the reserve ratio because the FDIC either (i)
consistently overestimates the anticipated failures or (ii) does not have
supporting data or analysis for its estimates. Each year, GAO audits the
financial statements of the BIF and the SAIF; the GAO has consistently
rendered unqualified opinions on those financial statements.

A. In your experience, has the FDIC consistently overestimated anticipated
failures?

No. As part of the annual financial statement audit, we have concluded that
FDIC?s estimates of its liabilities for anticipated failures were fairly
stated, in all material respects, based on information available at the
time. FDIC?s estimates for anticipated failures are generally based on the
most current information available at the time the estimates are made,
however, when the bank failure actually occurs, the amount of loss will
likely be different than originally expected.

B. In your experience, what has been the quality of the supporting analysis
by the FDIC of the reserve for anticipated failures?

Each year, during our annual financial statement audit we review the
methodology and information used by FDIC in determining the amount of the
estimated liability for anticipated failures. FDIC provides us with the
supporting documentation used in calculating the liability. We also perform
detailed tests on the supporting analysis and calculations. Based on our
annual audits of FDIC?s estimates, we have concluded that FDIC?s financial
statements were fairly stated, in all material respects, based on
information available at the time. The financial statements include FDIC?s
estimated liabilities for future failures.

C. Is that supporting analysis based on the probability of failure and the
probable loss given failure of specified individual institutions, rather
than on portfolio analysis of all institutions, no matter what their rating?

Yes. BIF and SAIF record an estimated liability for insured institutions
that are deemed probable to fail within 1 year of reporting. On a quarterly
basis, FDIC identifies five groups of insured institutions for analysis. The
first group consists of institutions classified as having a 100 percent
probability of failure. This determination is based on whether an
institution already has a scheduled closing date, the institution has been
classified as ?critically undercapitalized,? or the institution has been
identified as an imminent failure. The remaining four groups are based on
federal or state bank examinations, off- site ratings, and projected
capitalization levels. These insured institutions are then classified in one
of four groups: (1) CAMELS 4 with projected capital exceeding 2 percent, (2)
CAMELS 4 with projected capital below 2 percent, (3) CAMELS 5 with projected
capital exceeding 2 percent, or (4) CAMELS 5 with projected capital below 2
percent. Once the five

GAO- 02- 647R Responses to Questions on H. R. 3717 Page 5 groups are
established, FDIC applies a historical rate, or an adjusted historical rate
if

the circumstances warrant, to determine the amount of expected failed
assets. FDIC also determines a loss experience rate based on failed
institution assets that were unrecoverable by FDIC over the past 14 years.
Different loss experience rates are used for the five different groups of
institutions based on institution size, to reflect the historical loss
experience for institutions of different sizes. The loss experience rate is
multiplied by the expected failed assets for each institution in the five
groups to derive the estimated liability for anticipated failures.

D. Does the reserve for anticipated failures take into consideration
institutions with CAMELS ratings other than 4 or 5?

FDIC?s current methodology for estimating losses for anticipated failures
generally includes only insured institutions with CAMELS ratings of 4 and 5.
Just recently, however, a very rare instance occurred where a CAMELS 2
institution was included in the reserve because fraud was identified.

- - - - Should you or your staff have any questions, please contact me at
(202) 512- 9406 or Lynda Downing, Assistant Director, at (202) 512- 9168. We
can also be reached by email at franzelj@ gao. gov and downingl@ gao. gov.

Sincerely yours, Jeanette M. Franzel Acting Director Financial Management
and Assurance

(194129)
*** End of document. ***