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entitled 'Responses to Questions Relating to H.R. 3717, Federal Deposit 
Insurance Reform Act of 2002' which was released on April 16, 2002. 

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GAO-02-647R: 

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 fundís 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, FDICís 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.Ē 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 fundís assets to arrive at net worth for purposes of 
calculating the ratio? 

Currently, FDICís 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. BIFís and SAIFís 
net worth is called ďFund BalanceĒ on each fundís annual audited 
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 fundís
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 fundís 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 fundís 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 liability for anticipated failures to net 
worth in the calculation of the reserve ratio, the numerator will no 
longer represent the fundís 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 fundís 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, FDICís 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. 

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 FDICís estimates of its liabilities for anticipated failures were 
fairly stated, in all material respects, based on information available 
at the time. FDICís 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 FDICís estimates, we have concluded that 
FDICís financial statements were fairly stated, in all material 
respects, based on information available at the time. The financial 
statements include FDICís 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 
ďcritically undercapitalized,Ē 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 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? 

FDICís 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, 

Signed by: 
Jeanette M. Franzel: 
Acting Director: 
Financial Management and Assurance: 

[End of correspondence]