Farm Credit System: Analysis and Comment on Possible New Insurance
Corporation Powers (Letter Report, 08/05/96, GAO/GGD-96-144).

Pursuant to a legislative requirement, GAO reviewed the appropriateness
and major advantages of three proposals to increase the Farm Credit
System Insurance Corporation's (FCSIC) oversight powers over its
Insurance Fund.

GAO found that: (1) authorizing FCSIC to assess association capital
would provide short-term additional protection to the Insurance Fund,
investors, and taxpayers, but reasons for increased FCSIC power have
diminished and granting this authority could destabilize the Fund if the
authority were used during a period of financial stress; (2) the Farm
Credit Administration (FCA) needs to set adequate capital standards for
system banks and supervise and resolve any threats to the Fund; (3) FCA
has not demonstrated that giving FCSIC supplemental premium authority is
needed; (4) giving FCSIC supplemental premium authority could reduce the
system's ability to compete, increase its instability, and reduce bank's
ability to pay supplemental premiums; (5) if the system avoids major
losses, it should reach a secure base amount and continue to grow
gradually through investment income; (6) authorizing FCSIC to charge
higher premiums to banks that are most at risk could create additional
incentives for banks to manage risk prudently and complement FCA
risk-based capital requirements; and (7) FCSIC should be required to pay
interest on the $260 million used to start up the Fund, since this
interest represents a continuing subsidy.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-96-144
     TITLE:  Farm Credit System: Analysis and Comment on Possible New 
             Insurance Corporation Powers
      DATE:  08/05/96
   SUBJECT:  Farm credit
             Farm credit banks
             Farm income stabilization programs
             Capital
             Agricultural policies
             Bank management
             Insurance premiums
             Risk management
             Credit insurance
             Federal corporations
IDENTIFIER:  Farm Credit System
             FCSIC Insurance Fund
             
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Cover
================================================================ COVER


Report to Congressional Requesters

August 1996

FARM CREDIT SYSTEM - ANALYSIS AND
COMMENT ON POSSIBLE NEW INSURANCE
CORPORATION POWERS

GAO/GGD-96-144

Farm Credit System Insurance Corporation Powers

(233403)


Abbreviations
=============================================================== ABBREV

  FCA - Farm Credit Administration
  FCSIC - Farm Credit System Insurance Corporation

Letter
=============================================================== LETTER


B-259885

August 5, 1996

The Honorable Richard G.  Lugar
Chairman
The Honorable Patrick J.  Leahy
Ranking Minority Member
Committee on Agriculture, Nutrition,
 and Forestry
United States Senate

The Honorable Pat Roberts
Chairman
The Honorable E (Kika) de la Garza
Ranking Minority Member
Committee on Agriculture
House of Representatives

The Farm Credit System (the System) is a government-sponsored
enterprise that was chartered by Congress to ensure a stable supply
of credit to agriculture.  The Farm Credit System Insurance
Corporation (FCSIC) maintains the Insurance Fund, which insures the
prompt payment of most of the debt obligations of the System's eight
banks. 

The Farm Credit Banks and Associations Safety and Soundness Act of
1992 (the 1992 Act) required us to review and evaluate the
feasibility and appropriateness of three possible increases in
FCSIC's powers.  The System's regulator, the Farm Credit
Administration (FCA), had recommended each of these changes to
Congress in 1991.  Briefly, these powers, which are intended to
strengthen the Insurance Fund in a time of stress, would authorize
FCSIC to

  -- assess the capital of the 228 System associations that have
     ownership interest in the banks that fund them;\1

  -- charge supplemental insurance premiums to the banks; and

  -- base the premiums it charges banks on the relative riskiness of
     each bank. 

The objective of this report is to briefly describe our understanding
of each of these possible powers, FCA's stated reasons for requesting
them in 1991, and the major advantages and disadvantages we
anticipate were Congress to authorize them.  In addition, we reviewed
unimplemented recommendations regarding the Insurance Fund that we
made in a 1994 report to see whether they were still valid. 


--------------------
\1 An assessment of an association's capital could be accomplished,
for example, by a transaction that transfers certain association
assets without compensation. 


   BACKGROUND
------------------------------------------------------------ Letter :1

The System is a government-sponsored enterprise consisting of a
nationwide network of privately owned cooperative banks and their
related associations that provide billions of dollars of credit and
services to eligible farmers, ranchers, producers, cooperatives, and
others in rural America.  The System, like other government-sponsored
enterprises, raises funds in the capital markets at a relatively low
cost because of the strength of its ties to the federal government. 
Most System borrowing is done through the issuance of System-wide
debt obligations that are the joint and several liabilities of all
eight System banks.  This means that, in the event one or more banks
are unable to repay their respective obligations, the FCA can require
the remaining banks to repay the total amount of the obligations. 
However, the 228 System associations, which are the cooperative
owners of the banks in their respective geographical districts, are
not liable for the repayment of the banks' debts. 

The System nearly collapsed in the mid-1980s, and as a result,
investors began to lose confidence in the System's debt obligations. 
As we noted in a 1994 report, the System's problems were partly
caused by weak credit standards, ill-advised loan pricing, and
excessively risky financing policies that resulted in a costly
mismatch in the maturities of its liabilities compared to its
assets.\2 Under these circumstances, the System was unable to weather
the deflation of commodity and land values and the extreme volatility
in market interest rates in the early to mid-1980s.  At this point,
Congress decided to intervene before the System failed. 

In 1985, Congress began to devise a long-term plan to rescue the
System and prevent recurrence of the problems that led to its near
failure.  Up to that time, FCA had functioned as a part of the
System, with limited powers for dealing with financially troubled
institutions.  The Farm Credit Amendments Act of 1985\3 reconstituted
FCA as an arm's- length regulator with enforcement powers that
essentially parallel those of regulators of other federally insured
financial institutions.  Under this legislation, FCA was authorized
for the first time to issue cease and desist orders to banks and to
remove bank management. 

FCSIC was established under the Agricultural Credit Act of 1987\4
(the 1987 Act) as part of a recovery plan involving federal
assistance.  The initial capitalization of the FCSIC Insurance Fund
was provided by a $260 million transfer in 1989 of government funds
that were in a revolving fund and thus available to assist the
System.\5 Since that time, the reserves of the Insurance Fund have
increased through premiums paid by the System banks and by income
earned on its own investments.  FCSIC is authorized to assist
troubled System banks or the direct lender associations.  It is also
required to act as conservator or receiver if a System institution
fails. 

The Insurance Fund is not the last source of investor and taxpayer
protection because of the banks' joint and several obligation to
repay the insured debt.  However, that obligation cannot be invoked
until the Insurance Fund has first been depleted.  As of December 31,
1995, the amount of outstanding insured debt issued by System banks
was $58.5 billion.  The Insurance Fund equity balance was $902
million, or about 1.6 percent of the insured debt. 

The System's financial condition improved significantly between
year-ends 1990 and 1995.  Total System capital (excluding Insurance
Fund equity) increased from $5.4 billion to $8.8 billion during that
period.  Combined annual System earnings rose from $0.61 billion in
1990 to $1.2 billion in 1995.  The growth of net loans outstanding
has been gradual:  at year-end 1990, loans were $49.7 billion,
increasing to $56.9 billion at year-end 1995. 

FCSIC has experienced no significant losses in its regular insurance
operations.  FCSIC officials have indicated that none of the eight
banks is financially threatened at this time, and therefore the
Insurance Fund shows no additional provision for other losses.  The
Insurance Fund balance, which was $298 million in 1990, rose to $902
million as of December 31, 1995.  During this period, the ratio of
this balance to insured System debt rose from about 0.6 percent to
1.6 percent.  The Insurance Fund's year-end 1995 financial statement
also reflects a special one-time liability to repay debts that were
incurred in 1990 in connection with the federal rescue.\6 As of
December 1995, this liability was estimated to be $121 million. 

The 1987 Act requires that FCSIC assess premiums until the Insurance
Fund balance exceeds 2 percent of the insured obligations, or such
other percentage of the insured obligations as FCSIC in its sole
discretion determines is "actuarially sound."\7 This level is
referred to as the Secure Base Amount.  When the Fund balance, less
estimated expenses for the year, exceeds the Secure Base Amount,
FCSIC must reduce premiums to an amount sufficient to maintain the
Insurance Fund at the Secure Base Amount.  FCSIC has projected that
the Insurance Fund will reach the Secure Base Amount as early as
1998, assuming that no major losses will occur.  However, despite the
provisions that could reduce premiums, the Fund is expected to
continue to grow because of its investment income. 

Prior to 1996, FCSIC had no authority to limit this growth of the
Insurance Fund.  The Farm Credit System Reform Act of 1996\8 (the
1996 Act) will, in effect, constrain the amount of these excess Fund
balances by authorizing FCSIC to make partial distributions of the
excess balance each year.  These distributions can begin at any point
beyond 8 years after the Insurance Fund attains the Secure Base
Amount, but not before 2005. 


--------------------
\2 Farm Credit System:  Farm Credit Administration Effectively
Addresses Identified Problems (GAO/GGD-94-14, Jan.  7, 1994). 

\3 P.L.  99-205, 99 Stat.  1678. 

\4 P.L.  100-233, 101 Stat.  1568. 

\5 Unlike other federal assistance provided to the System under the
1987 Act, which must be repaid, there is no provision for repaying
this amount. 

\6 The details of the plan to repay federal assistance were explained
in our 1994 report Farm Credit System:  Repayment of Federal
Assistance and Competitive Position (GAO/GGD-94-39, Mar.  10, 1994). 

\7 For the purpose of calculating the amount of insured obligations,
FCSIC is required to reduce the actual amount outstanding by a
percentage of the System's loans that are guaranteed by the federal
government or state governments. 

\8 P.L.  104-105, 110 Stat.  162. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

In 1991, FCA recommended to Congress that FCSIC be authorized to
assess the capital of associations, if needed, in order to restore
financial soundness to the Fund or a troubled bank.  Authorizing
FCSIC to assess association capital would, in the short term, provide
additional protection to the Insurance Fund, investors in System
debt, and ultimately the taxpayers.  However, the concerns that
formed the basis for this recommendation, such as the limited size of
the Fund or the adequacy of capital in System banks, have diminished
over time.  Moreover, if FCSIC had this authority and tried to
implement it during a period of financial stress, there is some risk
that the result would be the withdrawal of a significant number of
individual member/borrowers from their associations.  The System and
the Insurance Fund could thus suffer some degree of destabilization
instead of benefiting from the additional protection that capital
assessments were intended to provide. 

Currently, FCSIC premiums are established in law and cannot be
increased by FCSIC.  FCA also recommended that FCSIC be authorized to
charge supplemental premiums to banks in case the Insurance Fund
appeared inadequate to meet projected needs.  While such premiums
might appear to be justified if the Insurance Fund experienced major
losses, the size of such premiums would likely be limited by adverse
industry conditions and competitive considerations at such a time. 

The Insurance Fund has completed its start-up phase and is expected
to reach the target amount as early as 1998, so that ordinary
premiums will likely no longer be assessed.  Even so, the Fund is
expected to continue growing for several years thereafter because of
its investment income.  The 1996 Act was designed, in part, to limit
the growth of the Fund.  However, if the reserves do accumulate as
expected, the probability that FCSIC might need to charge
supplemental premiums would correspondingly decrease.  As a result,
authorizing FCSIC to charge supplemental insurance premiums has the
potential to be counterproductive in a crisis and does not appear
necessary. 

Finally, FCA recommended that FCSIC be authorized to incorporate
additional risk factors into its premium structure to require higher
risk banks to pay higher premium rates.  FCSIC premiums are already
based in part on credit risk but not on other forms of risk, such as
interest rate risk.  Giving FCSIC the authority to charge premiums
that are more fully based on all risks than at present could create
additional incentives for banks to manage risk prudently, because
banks that were judged to be riskier would be expected to pay higher
premiums.  Used in this way, risk-based premiums could be a useful
complement to the FCA's risk-based capital requirements. 

In our March 1994 report, we recommended that FCSIC be required to
repay $260 million in government funds that had been transferred to
the Insurance Fund as its initial capitalization.  This
recommendation is consistent with the overall policy of the 1987 Act
that federal assistance to the System be repaid.  In recent years,
both the growth of the Insurance Fund and the System's recovery have
supported the view that these funds are no longer needed.  Moreover,
because FCSIC pays no interest on the unpaid balance of these funds,
it in effect receives a continuing federal subsidy. 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
------------------------------------------------------------ Letter :3

Section 204 of the 1992 Act mandated our study of two specific
aspects of the Farm Credit System and of FCSIC.\9 First, we were to
study the impact on the System of a growing trend toward mergers and
consolidations of the banks.  This trend was described in our 1994
report Farm Credit System:  Potential Impacts of FCB Mergers on
Farmer and Rancher Borrowers (GAO/GGD-95-19, Dec.  2, 1994).  Second,
the act required us to study the feasibility and appropriateness of
three specific options to increase FCSIC's powers to (1) directly or
indirectly assess association capital, (2) assess supplemental
insurance premiums, and (3) establish a risk-based insurance premium
system.  The primary purpose of this report is to fulfill this second
part of the 1992 Act's mandate. 

To address these issues, we reviewed the statutes and legislative
history of FCSIC, our previous reports, and records of pertinent
congressional hearings.  We identified and reviewed three of FCA's
1991 legislative recommendations that were related to the issues in
our mandate.  We had numerous discussions with FCSIC and FCA staff
and reviewed relevant correspondence, memoranda, legal opinions, and
financial statements of the System and of the FCSIC Insurance Fund
over the past 6 years.  We did not audit or verify these financial
data, all of which were provided to us by FCSIC and FCA officials. 
We reviewed the basis for FCA's 1991 legislative recommendations
pertaining to increased powers for FCSIC.  We also reviewed a report
done by a System task force that presented its response to these FCA
recommendations.  In addition, we reviewed our previous
recommendations from a 1994 report regarding the Insurance Fund to
determine whether any that had not yet been adopted should be further
considered at this time.\10

We did our work between June 1994 and March 1996 at FCSIC and FCA
headquarters, which are both located in McLean, Virginia, in
accordance with generally accepted government auditing standards. 

We obtained written comments from FCSIC, FCA, and the System on a
draft of this report.  We have reprinted their letters in appendixes
I through III.  The comments are summarized and evaluated at the end
of this report. 


--------------------
\9 Farm Credit Banks and Associations Safety and Soundness Act of
1992, P.L.  102-552, 106 Stat.  4102. 

\10 Farm Credit System:  Repayment of Federal Assistance and
Competitive Position (GAO/GGD-94-39, Mar.  10, 1994). 


   FCSIC ACCESS TO ASSOCIATION
   CAPITAL COULD BOTH PROVIDE SOME
   PROTECTION AND CAUSE SYSTEM
   INSTABILITY
------------------------------------------------------------ Letter :4

If the Insurance Fund were to be depleted, the next layer of
protection against losses for investors in Systemwide debt and for
taxpayers is represented by the capital of the eight Farm Credit
Banks.  In 1991, FCA was concerned that the association capital did
not also stand behind this FCSIC-insured debt.  For that reason, FCA
recommended to Congress in 1991 that association capital be exposed
to this debt by authorizing FCSIC to assess the capital of
associations, if needed, in order to restore financial soundness to
the Insurance Fund or a troubled bank.\11 FCA's concern was that,
after 1987, banks had no means of requiring associations to
contribute capital to the Insurance Fund. 

FCA cited three additional issues in support of its recommendation. 
Two of these issues have diminished since 1991.  First, uncertainty
about the System's return to financial health, noted by FCA at the
time, is no longer a major concern because the System has recovered
significantly.  Second, the Insurance Fund, which was very small in
1991, is now approaching the Secure Base Amount.  The third concern
of FCA was that bank capital had been declining as a percentage of
total System capital.  This issue could be addressed simply by
requiring that the banks maintain, as FCA believes they now do, an
acceptable level of capital.  However, even if these additional
issues are no longer of serious concern, this does not settle the
basic question of whether drawing upon the associations' capital is
an acceptable way to support the Insurance Fund and the banks, should
the need arise. 

While the concept of assessing associations to support the Insurance
Fund, back up the insured debt, and prevent losses to taxpayers may
appear reasonable, it could be difficult and perhaps impractical to
implement for three reasons.  First, the System structure is such
that a System bank does not have the power to require financial
support from its member associations, because it does not own
them.\12 The situation is additionally complicated by the fact that
each of the 228 associations is an independent entity.  Association
stock is owned solely by its member borrowers, and each association
is governed by a board of directors elected from its own membership. 

Second, a FCSIC program to assess the capital of associations could
result in assessments on well-managed and well-capitalized
associations that were not responsible for the problems experienced
by the less solvent associations.  Granting FCSIC the power to
distribute capital assessments among the associations would raise
difficult questions of equity.  More importantly, depending on how it
was implemented, this power could create various incentives for
behavior that might ultimately diminish investor protection.  For
example, knowing that their capital might be assessed at some future
time, associations would have a disincentive to accumulate any more
capital than the regulatory minimum. 

Third, the threat of a capital assessment against associations could
destabilize even the strongest of them and thus aggravate the
condition of an already troubled System.  For example,
destabilization could result if an association's most creditworthy
borrowers--those who were able to obtain credit elsewhere at an equal
or lower interest rate--were to prepay loans.  These prepayments
could reduce the capital of the association through the redemption of
these members' stock.  In addition, because only the strongest
borrowers would likely be able to prepay, the transactions would
result in lowering the average quality of the remaining loan
portfolio.  At that point, to maintain or restore fiscal soundness,
the association's loan rates could be expected to rise and its
dividends to members fall, making new farm loans difficult to
attract.  Many associations experienced these problems in the 1980s. 
While we cannot estimate the probability of this happening again, we
regard this potential risk as a major disadvantage of the FCA
proposal. 

There is also the question of how a capital transfer would be
accomplished.  In this mandated review, we were asked to comment on a
specific type of transaction that might be considered a capital
transfer--that is, an association's purchase of additional bank
stock, paid for by borrowing under the association's line of credit
at the bank.  This transaction would transfer capital to the bank. 
However, the ability of associations to pay the note and remain
competitive is questionable.  To repay the note, the association
would need to increase its earnings--probably by raising rates on
loans and reducing dividends to members.  If the association proved
unable to repay the note, the bank capital that was created by the
association's purchase of stock would be decreased. 

As an alternative, the association could contribute to its bank
certain association assets, such as a portion of its seasoned
portfolio of loans with an established record of satisfactory
performance.  However, several factors might constrain the amount of
association capital that could be transferred in this way.  These
factors include FCA's minimum capital requirements for associations,
the minimum amount of assets that associations must have to
collateralize their regular borrowings, and the impact of the
contribution on the association's future profitability.  FCSIC's
implementation of assessments that could be paid in this way would
require difficult judgments, and would be subject to these
constraints. 

In summary, the reasons for asking for this power to transfer
association capital have decreased in importance with the improvement
in the financial condition of both the System and the Insurance Fund
since 1991.  Both the potential and actual exercise of this power
could raise concerns about System stability.  Additionally, in our
view, it is especially important that FCA set adequate capital
standards for the banks and that any problems be promptly identified
and resolved to minimize threats to the Insurance Fund.  Moreover, it
is essential that the associations have adequate capital and be well
supervised, because the financial strength of each bank is largely
dependent on the health of its member associations. 


--------------------
\11 As of December 31, 1995, total System capital was $8.8 billion. 
This comprised $3.2 billion in bank capital and $5.6 billion in
association capital. 

\12 Banks do have the power to assess member associations for their
prorated share of FCSIC premiums.  However, revenue from this source
would not provide significant support to a troubled bank. 


   THE NEED FOR SUPPLEMENTAL
   PREMIUM AUTHORITY HAS NOT BEEN
   DEMONSTRATED
------------------------------------------------------------ Letter :5

FCSIC premiums are established by statute and cannot be increased,
regardless of any adverse condition experienced by the Insurance
Fund.  In 1991, FCA recommended that FCSIC be authorized to charge
supplemental premiums to the banks.  Such premiums could help the
Fund recover more rapidly if large losses were to occur.  FCA
believed that a major bank failure might result in costs that would
overwhelm the Insurance Fund, and that an immediate and possibly very
large supplemental premium might be needed to restore Fund soundness. 
However, in 1995, FCA officials indicated to us that they no longer
supported this recommendation.  FCSIC officials concurred that
supplemental premium authority was not necessary. 

We believe FCSIC's position is acceptable for two reasons: 

  -- The cost of a major supplementary premium would have to be
     passed along to the System's member/borrowers, and this could
     impair the System's ability to compete or increase its potential
     for instability. 

  -- The ability of banks to pay supplemental premiums is likely to
     be diminished at the very time the Fund would be most in need of
     them, because of the tendency of unfavorable conditions to
     affect most or all of the banks. 

In addition to these factors, the System's recovery and the growth of
the Insurance Fund diminish the likelihood that supplementary premium
authority is justified.  The Insurance Fund balance is now
approaching the Secure Base Amount set by the statute, a condition
that did not exist several years ago.  As of year-end 1995, the
balance was $902 million, or about 1.6 percent of the $58.5 billion
in FCSIC-insured obligations.  In April 1996, FCSIC projected that,
if no major losses occur, the Fund will reach the Secure Base Amount
as early as 1998.  When the Fund exceeds the Secure Base Amount,
FCSIC must reduce its annual premiums to an amount sufficient to
maintain the Insurance Fund at the Secure Base Amount. 

If the System avoids major losses in the next several years and the
Insurance Fund reaches the Secure Base Amount, the Fund should
continue to grow gradually because of its investment income, even
though no premiums are assessed.  For example, the Fund had
investment income of about $54.7 million in 1995, while
administrative operating expenses were relatively minor at $1.4
million. 

The 1996 Act provides a mechanism which will, in effect, constrain
the future growth of the Insurance Fund.  For each year that the Fund
balance exceeds the Secure Base Amount, the amount of the excess,
after subtracting projected FCSIC operating expenses and insurance
obligations for the next year, will be credited to a group of
Allocated Insurance Reserves Accounts (reserve accounts) established
for each bank.  These accounts are still part of the Insurance Fund
and available to FCSIC.  According to a FCSIC official, the amounts
to be credited will be recalculated each year and will
replace--rather than be added to--the amounts allocated in the
preceding year.  The amount of funds in the allocated reserve
accounts each year will likely fluctuate, depending upon the annual
calculation of the Secure Base Amount and any excess Insurance Fund
balance. 

Before the 1996 Act was passed, FCSIC had no authority to repay to
the banks any balance in the Insurance Fund that exceeded the Secure
Base Amount.  The 1996 Act authorizes FCSIC to make such repayments
to the banks from their respective reserve accounts, beginning at any
point beyond 8 years after the date when the Secure Base Amount is
first reached, but not earlier than January 2005.\13 In the meantime,
FCSIC projects that the Insurance Fund could continue to grow beyond
the Secure Base Amount and that by 2006 the excess balance might be
in the range of $250 million to $400 million, or between 0.35 percent
and 0.75 percent of insured obligations. 

If and when annual payments do begin, they are to include 20 percent
of the excess year-end Fund balance, subject to certain conditions
and adjustments.  Therefore, the Fund should continue to hold more
resources than the Secure Base Amount if no major insurance losses
occur.  Assuming favorable industry conditions continue, these
reserves will provide additional protection to investors and are to
be allocated at a time when the banks are no longer paying premiums
and the industry is doing well.  To that extent, such additions are
preferable to supplemental premiums that FCSIC might attempt to
assess during troubled times. 

The need to charge supplemental premiums--like the need to assess the
capital of the associations--can best be avoided by strong capital
standards and timely and effective supervision of all System
institutions.  Moreover, the joint and several liability of the banks
remains as the final layer of protection to System investors and
taxpayers. 


--------------------
\13 The 1996 Act provides for a one-time initial payment that
includes, in addition to the regular annual payment, the amounts that
would have been payable for each of the preceding 3 years, with
interest accrued to the payment date. 


   PREMIUMS ARE NOT BASED ON ALL
   BANK RISKS
------------------------------------------------------------ Letter :6

FCSIC already charges risk premiums according to a formula that takes
some account of the credit risk in System loans.  The annual
statutory premium paid by each bank is higher for nonperforming loans
(0.25 percent) than it is for performing loans (0.15 percent).\14 In
1991, FCA recommended that FCSIC be authorized to further
differentiate the premium structure.  FCA recognized that FCSIC could
not change the premiums it charged individual banks, although the
relative risk to the Insurance Fund could vary by bank.  For example,
FCA cited interest rate risk, which could result from mismatched
maturities of assets and liabilities, as a factor that could expose a
bank to major losses if market interest rates changed. 

If FCSIC were to charge premiums based on differences in the various
banks' capital-to-assets ratio, it would also have a risk-based
premium system.  This would be similar to the arrangement that the
Federal Deposit Insurance Corporation uses to charge deposit
insurance premiums to insured thrifts and commercial banks, with the
institutions posing the greatest threat to the Insurance Fund--those
with the lowest level of risk-adjusted capital--generally paying more
for their insurance.  Under this arrangement, the riskier
institutions have a financial incentive to reduce their high premium
expenses; they can do this either by maintaining a high level of
capital to compensate for the risks they take or by reducing their
riskiness.  It follows that FCSIC's implementation of risk-based
premiums could compensate FCSIC for these non-credit risks where they
exist and provide incentives for the banks to properly manage their
risks. 

There may be a concern that such an arrangement could be used to
raise average premiums and thus serve as a back door approach to
supplemental premiums.  However, if higher premiums were not the
goal, the authorization for FCSIC could specify that the total
estimated premium revenue raised by the new procedure must not exceed
the estimated revenue that would have been raised under the existing
premium structure.  This would result in increased premiums at higher
risk banks and lower premiums at lower risk banks than under the
current premium system. 


--------------------
\14 For the purpose of calculating premiums, nonperforming loans are
measured at the retail level of individual borrowers rather than at
the level of the banks' wholesale loans to its member associations. 
Premium rates are substantially reduced for performing loans that
carry federal or state guarantees. 


   FEDERAL SUBSIDY OF FCSIC SHOULD
   BE TERMINATED
------------------------------------------------------------ Letter :7

In our previously cited March 1994 report regarding the System's
repayment of federal assistance,\15 we noted that a $260 million
payment of government funds was made to start up the Insurance Fund
in 1989.  We recommended that Congress require that the funds be
repaid to the Treasury.  As of April 1996, no action had been taken
regarding this recommendation. 

This payment of government funds, which represented the Insurance
Fund's initial capital, came at a time when the System's capacity to
support the Insurance Fund's commitments was in doubt.  The payment
came from federal revolving funds.  The funds were available to FCA
to make temporary capital stock investments in System
institutions.\16

The $260 million, together with the investment income that FCSIC
earns on it, represents a continuing federal subsidy of the System. 
Repayment of these funds to the general fund of the Treasury--and not
to the former revolving funds--would be consistent with the overall
policy of the Agricultural Credit Act of 1987 that the System repay
federal aid.  Congress employed this principle with previous
industry-financed insurance funds in the 1950s and in the more recent
reform of commercial bank deposit insurance.\17 Moreover, the
substantial recovery of the System and growth of the Insurance Fund
have made this an opportune time to consider how and when the subsidy
should be repaid. 

Assuming that a repayment program might extend over a period of
years, FCSIC could reduce the federal subsidy by paying interest to
the Treasury on the unpaid balance.  The Insurance Fund's investments
are in U.S.  Treasury obligations.  A FCSIC official reported to us
that the Fund earned approximately $154.8 million in investment
income from the time of the federal payment on May 5, 1989, through
December 31, 1995.  While we do not suggest that these past earnings
should also be paid to the Treasury, future investment income will
represent a significant continuing annual federal subsidy unless the
Insurance Fund begins to pay interest on the $260 million. 


--------------------
\15 GAO/GGD-94-14. 

\16 The federal government provided such start-up capital for System
institutions beginning in 1929.  All such investments were fully
repaid by 1968.  Thereafter, the revolving funds were available to
FCA until their transfer to the Insurance Fund in 1989. 

\17 The Federal Deposit Insurance Corporation Improvement Act of
1991, P.L.  102-242, 105 Stat.  2236. 


   CONCLUSIONS
------------------------------------------------------------ Letter :8

From our review of the three specific options for increasing FCSIC's
powers recommended to Congress by FCA in 1991, we determined that the
first two are not currently needed, but that the third could be
useful.  Specifically, the first option of authorizing FCSIC to
assess the capital of the Farm Credit associations could provide
additional short-term protection to the Insurance Fund, investors in
System debt, and taxpayers.  However, implementing this option could
also result in unacceptable destabilization of the System. 

The second option, authorizing FCSIC to charge supplemental premiums,
does not appear attractive because the amount of revenue that could
be raised would likely be limited by adverse industry conditions and
competitive considerations.  The probable need for such premiums has
also been diminished now that the Insurance Fund has completed its
start-up phase. 

Finally, the third option, authorizing FCSIC to charge premiums that
are more fully based on risk, would be a useful complement to FCA's
risk-based capital requirements. 

In addition, we believe our 1994 recommendation--that FCSIC repay the
$260 million in government funds used to start up the Insurance
Fund--remains valid.  The investment income earned by FCSIC on this
$260 million, or any unpaid balance, represents a continuing federal
subsidy, because FCSIC is not required to pay interest to the
government.  Thus, we also believe that, regardless of whether FCSIC
repays the entire $260 million or any part of that amount, paying
interest on the unpaid balance would reimburse the government for the
use of its funds. 


   RECOMMENDATION TO CONGRESS
------------------------------------------------------------ Letter :9

While we continue to believe that FCSIC should be required to repay
the entire amount of government funds, we also recommend that, until
this occurs, Congress require FCSIC to pay interest to the government
on the unpaid balance of the original $260 million that was
transferred to it in 1989. 


   AGENCY COMMENTS AND OUR
   EVALUATION
----------------------------------------------------------- Letter :10

FCSIC, FCA, and the System (through the Farm Credit Council) provided
written comments on a draft of this report.  Their comments are
reprinted in appendixes I through III.  Additional technical comments
were provided and have been incorporated throughout the report as
appropriate. 

All three organizations generally agreed with our conclusions that
the options of authorizing FCSIC to assess the capital of
associations and to charge supplemental premiums are not needed at
this time.  However, FCA and FCSIC commented that, under certain
circumstances, Congress might want to revisit these issues in the
future.  These circumstances could include significant deterioration
in the System's financial condition or substantial System structural
changes, including a continuation of the trend of bank consolidation
and mergers.\18 If the number of banks fell substantially, relatively
few banks might remain that were subject to the joint and several
liability provisions and thus available to share in System losses. 

If the System and the Insurance Fund were to experience a financial
emergency that called for congressional attention, the issues of
capital assessment and supplemental insurance premiums could be
raised.  The nature of the solution would depend upon the nature of
the emergency, and is therefore difficult to predict.  While these
particular solutions could be a part of the recovery plan that
Congress developed, they would be subject to the difficulties we
discussed in the report. 

FCSIC and FCA generally agreed with our conclusion that FCSIC should
have the authority to charge risk-based premiums.  However, they
noted that it would be difficult to develop a premium structure that
fully addressed all the risks to which a bank is subject.  The System
stated its view that the existing risk-based premium structure was
not in need of revision.  It noted that any alternative to the
current premium structure would have to be carefully scrutinized to
determine whether it would create specific and appropriate incentives
and disincentives for System institutions.  Additionally, the System
pointed out that, with the anticipated achievement of the Secure Base
Amount within the next few years and the resulting suspension of
premiums, there would be little benefit gained from the revision of
the premium structure at this time.  This limitation could be
overcome, however, by amending FCSIC's current statutory authority to
collect premiums.  For example, rather than requiring FCSIC to reduce
or possibly suspend premiums when the Insurance Fund reaches the
Secure Base Amount, FCSIC could be authorized to assess premiums on
banks that posed greater than average risk to the insurance fund,
provided that an equal amount were paid to banks posing less than
average risk.  In that case, while there would be no net premiums
charged to the System, relative premiums would be related to relative
riskiness. 

FCSIC, FCA, and the System expressed concerns about our
recommendation to Congress that FCSIC repay the $260 million in
government funds used to initially capitalize the Insurance Fund. 
While neither FCSIC nor FCA disagreed with our recommendation, they
both stated that consideration should be given to how the repayment
of the $260 million could affect FCSIC's ability to protect investors
in System debt.  FCSIC also expressed the concern that the immediate
payment of the entire $260 million could potentially undermine
investor confidence in the Insurance Fund's ability to protect them. 
We agree that repayment of these funds should be scheduled so that
the Insurance Fund is not significantly affected.  Thus, repayment
could be expected to take several years.  Because of the time value
of these funds, we believe that the Treasury should receive interest
on the outstanding balance.  Further, the interest rate should be
related to the investment income earned on FCSIC's investment
portfolio. 

FCSIC stated its belief that the System, rather than the Insurance
Fund, was the recipient of the federal subsidy represented by the
$260 million in government funds.  In our view, the original transfer
to the Insurance Fund provided FCSIC liquid resources to assist or
close troubled institutions.  FCSIC's immediate credibility to
investors in Systemwide debt should have been enhanced by this
transfer.  FCSIC staff has estimated that, from the initial transfer
through year-end 1995, the Insurance Fund earned approximately $154.8
million of investment income on these funds.  The initial transfer
plus this investment income accounts for about $414.8 million, or
about 46 percent of the Fund balance at year-end 1995. 

In the long run, the System is the primary beneficiary of the
transfer, because potential major insurance losses would be paid for
in part by funds that the System had not provided.  In addition, the
Insurance Fund could reach the Secure Base Amount several years
earlier than would be true if the transfer had not been received,
thus saving the System a significant amount of future premium
expense.  Investors in insured System debt have also benefitted from
the accelerated growth of the Insurance Fund that resulted from the
transfer. 

The System disagreed with our recommendation, stating that its views
had not changed from the time we initially made our recommendation. 
The System continues to believe that using the $260 million in former
FCA revolving funds is consistent with their historical use and does
not reduce the industry-financed nature of the Insurance Fund. 
However, as we noted in our earlier report, the amounts in the
revolving fund were not originally supplied by System institutions,
but rather by taxpayers in general.  Thus, this portion of the
Insurance Fund cannot be said to have been industry-financed. 

We are sending copies of this report to the Chairman of FCSIC and the
Chairman of FCA, as well as to the Farm Credit System's Presidents'
Planning Committee.  We will also make copies available to others
upon request. 

Major contributors to this report were Charles M.  Roberts, Senior
Evaluator, and Edward S.  Wroblewski, Senior Evaluator.  If you or
any of your staff have any questions or comments on this report,
please call me on (202) 512-8678. 

Thomas J.  McCool
Associate Director, Financial Institutions
 and Markets Issues



(See figure in printed edition.)Appendix I

--------------------
\18 See our report Farm Credit System:  Potential Impacts of FCB
Mergers on Farmer and Rancher Borrowers (GAO/GGD-95-19, Dec.  2,
1994), on System bank mergers. 


COMMENTS FROM THE FARM CREDIT
INSURANCE CORPORATION
============================================================== Letter 

See p.  14. 

See p.  14. 



(See figure in printed edition.)

See pp.  14 and 15. 

See pp.  15 and 16. 



(See figure in printed edition.)

Now on p.  10. 




(See figure in printed edition.)Appendix II
COMMENTS FROM THE FARM CREDIT
ADMINISTRATION
============================================================== Letter 

See p.  14. 

See pp.  14 and 15. 

See pp.  15 and 16. 



(See figure in printed edition.)




(See figure in printed edition.)Appendix III
COMMENTS FROM THE FARM CREDIT
SYSTEM
============================================================== Letter 

See pp.  15 and 16. 

See pp.  14 and 15. 

See pp.  14 and 15. 



(See figure in printed edition.)

See pp.  15 and 16. 

*** End of document. ***