Seventh Edition - The Addison-Wesley Series in Economics Phần 5 pot

Increased bank capital reduces moral hazard incentives forthe bank, because the bank now has more to lose if it fails and so is less likely to take on too much risk.. See Table 1, which

Moral Hazard and the Government Safety Net.

Box 1: Global

The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing?

Adverse Selection and the Government Safety Net.

“Too Big to Fail.”

Financial Consolidation and the Government Safety Net.

Bank Supervision:

Chartering and

Examination

CAMELS rating

cease and desist orders

Box 2: Global

Basel 2: Is It Spinning Out of Control?

call reports

Assessment of

Risk Management

Requirements

Electronic Banking: New Challenges for Bank Regulation

Box 3: E-Finance

Table 1 Major Banking Legislation in the United States in the Twentieth Century

(continues)

International Banking Regulation

The 1980s U.S Banking Crisis: Why?

F I G U R E 1 Bank Failures in the United States, 1934–2002

1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 0

50

25

75 100 150 200

Number of Bank

Failures

125 175 225

highly leveraged transaction loans

Early Stages of

the Crisis

Later Stages of

the Crisis:

Regulatory

Forbearance

The Principal–

Agent Problem for

Regulators and

Politicians

Savings and Loan Bailout: The Financial Institutions Reform, Recovery, and Enforcement Act of 1989

Banking Crises Throughout the World

Scandinavia

Source: Managing the Real and Fiscal Effects of Banking Crises

Table 2 The Cost of Rescuing Banks in Several Countries

Russia and

Eastern Europe

jusen jusen

“Déjà Vu All

Over Again”

East Asia

Summary

Key Terms

Web Exercises

FDICIA is a major step in reforming the banking regulatory system How well will itwork to solve the adverse selection and moral hazard problems of the bank regulatorysystem? Let’s use the analysis in the chapter to evaluate the most important provisions

of this legislation to answer this question

appli-cation, try to reason out how well they will solve the current problems with bankingregulation This exercise will help you develop a deeper understanding of the mate-rial in this chapter

FDICIA’s reduction of the scope of deposit insurance by limiting insurance on kered deposits and restricting the use of the too-big-to-fail policy might haveincreased the incentives for uninsured depositors to monitor banks and to withdrawfunds if the bank is taking on too much risk Because banks might now fear the loss

bro-of deposits when they engage in risky activities, they might have less incentive to take

on too much risk Limitations on the use of the too-big-to-fail policy starting in 1992have resulted in increased losses to uninsured depositors at failed banks as planned.Although the cited elements of FDICIA strengthen the incentive of depositors tomonitor banks, some critics of FDICIA would take these limitations on the scope ofdeposit insurance even further Some suggest that deposit insurance should be elim-inated entirely or should be reduced in amount from the current $100,000 limit to,

say, $50,000 or $20,000 Another proposed reform would institute a system of

coin-surance in which only a percentage of a deposit—say, 90%—would be covered by

insurance In this system, the insured depositor would suffer a percentage of thelosses along with the deposit insurance agency Because depositors facing a lower limit

on deposit insurance or coinsurance would suffer losses if the bank goes broke, theywill have an incentive to monitor the bank’s activities Other critics believe that FDICIAprovides too much support for the too-big-to-fail policy Because under FDICIA theFed, the Treasury, and the FDIC can still agree to implement too-big-to-fail and thusbail out uninsured as well as insured depositors, big banks will not be subjected toenough discipline by uninsured depositors These critics advocate eliminating thetoo-big-to-fail policy entirely, thereby decreasing the incentives of big banks to take

on too much risk

However, other experts do not believe that depositors are capable of monitoringbanks and imposing discipline on them The basic problem with reducing the scope

of deposit insurance even further as proposed is that banks would be subject to runs,sudden withdrawals by nervous depositors Such runs could by themselves lead tobank failures In addition to protecting individual depositors, the purpose of depositinsurance is to prevent a large number of bank failures, which would lead to an unsta-ble banking system and an unstable economy as occurred periodically before theestablishment of federal deposit insurance in 1934 From this perspective, federaldeposit insurance has been a resounding success Bank panics, in which there aresimultaneous failures of many banks and consequent disruption of the financial sys-tem, have not occurred since federal deposit insurance was established

On the one hand, evidence that the largest banks benefiting from the de facto big-to-fail policy before 1991 were also the ones that took on the most risk suggeststhat limiting its application, as FDICIA does, may substantially reduce risk taking Onthe other hand, eliminating the too-big-to-fail policy altogether would also cause some

too-of the same problems that would occur if deposit insurance were eliminated orreduced: The probability of bank panics would increase If a big bank were allowed tofail, the repercussions in the financial system might be immense Other banks with acorrespondent relationship with the failed bank (those that have deposits at the bank

in exchange for a variety of services) would suffer large losses and might fail in turn,leading to a full-scale panic In addition, the problem of liquidating the big bank’s loanportfolio might create a major disruption in the financial market

The prompt corrective action provisions of FDICIA should also substantially reduceincentives for bank risk taking and reduce taxpayer losses FDICIA uses a carrot-and-stick approach to get banks to hold more capital If they are well capitalized, theyreceive valuable privileges; if their capital ratio falls, they are subject to more andmore onerous regulation Increased bank capital reduces moral hazard incentives forthe bank, because the bank now has more to lose if it fails and so is less likely to take

on too much risk

In addition, encouraging banks to hold more capital reduces potential losses forthe FDIC, because increased bank capital is a cushion that makes bank failure lesslikely Furthermore, forcing the FDIC to close banks once their net worth is less than2% (group 5) rather than waiting until net worth has fallen to zero makes it morelikely that when a bank is closed, it will still have a positive net worth, thus limitingFDIC losses

Prompt corrective action, which requires regulators to intervene early when bankcapital begins to fall, is a serious attempt to reduce the principal–agent problem forpoliticians and regulators With prompt corrective action provisions, regulators nolonger have the option of regulatory forbearance, which, as we have seen, can greatlyincrease moral hazard incentives for banks

Some critics of FDICIA feel that there are too many loopholes in the billthat still allow regulators too much discretion, thus leaving open the possibility ofregulatory forbearance However, an often overlooked part of the bill increases theaccountability of regulators FDICIA requires a mandatory review of any bank failurethat imposes costs on the FDIC The resulting report must be made available to anymember of Congress and to the general public upon request, and the GeneralAccounting Office must do an annual review of these reports Opening up the actions

of the regulators to public scrutiny will make regulatory forbearance less attractive to

Prompt

Corrective

Action

Under FDICIA, banks deemed to be taking on greater risk, in the form of lower ital or riskier assets, will be subjected to higher insurance premiums Risk-basedinsurance premiums will consequently reduce the moral hazard incentives for banks

cap-to take on higher risk In addition, the fact that risk-based premiums drop as thebank’s capital increases encourages the bank to hold more capital, which has the ben-efits already mentioned

One problem with risk-based premiums is that the scheme for determining theamount of risk the bank is taking may not be very accurate For example, it might

be hard for regulators to determine when a bank’s loans are risky Some critics havealso pointed out that the classification of banks by such measures as the Basel risk-based capital standard solely reflects credit risk and does not take sufficient account

of interest-rate risk The regulatory authorities, however, are encouraged by FDICIA

to modify existing risk-based standards to include interest-rate risk and, as we haveseen earlier in the chapter, have proposed guidelines to encourage banks to manageinterest-rate risk

FDICIA’s requirements that regulators perform bank examinations at least once a yearare necessary for monitoring banks’ compliance with bank capital requirements andasset restrictions As the S&L debacle illustrates, frequent supervisory examinations

of banks are necessary to keep them from taking on too much risk or committingfraud Similarly, beefing up the ability of the Federal Reserve to monitor foreign banksmight help dissuade international banks from engaging in these undesirable activities.The stricter and more burdensome reporting requirements for banks have theadvantage of providing more information to regulators to help them monitor bankactivities However, these reporting requirements have been criticized by banks,which claim that the requirements make it harder to lend to small businesses

Regulatory Consolidation. The current bank regulatory system in the United Stateshas banking institutions supervised by four federal agencies: the FDIC, the Office ofthe Comptroller of the Currency, the Office of Thrift Supervision, and the FederalReserve Critics of this system of multiple regulatory agencies with overlapping juris-dictions believe it creates a system that is too complex and too costly because it is rifewith duplication The Clinton administration proposed a consolidation in which theduties of the four regulatory agencies would be given to a new Federal BankingCommission governed by a five-member board with one member from the Treasury,one from the Federal Reserve, and three independent members appointed by thepresident and confirmed by the Senate The Federal Reserve strongly opposed thisproposal because it believed that it needed to have hands-on supervision of the largestbanks through their bank holding companies (as is the case currently) in order tohave the information that would enable the Fed to respond sufficiently quickly in acrisis The Fed also pointed out that a monolithic regulator might be less effectivethan two or more regulators in providing checks and balances for regulatory supervi-sion The Clinton administration’s proposal was not passed by Congress, but the issue

of regulatory consolidation is sure to come up again

Market-Value Accounting for Capital Requirements. We have seen that the requirementthat a bank have substantial equity capital makes the bank less likely to fail Therequirement is also advantageous, because a bank with high equity capital has more

to lose if it takes on risky investments and so will have less incentive to hold riskyassets Unfortunately, capital requirements, including new risk-based measures, arecalculated on a historical-cost (book value) basis in which the value of an asset is set

at its initial purchase price The problem with historical-cost accounting is thatchanges in the value of assets and liabilities because of changes in interest rates ordefault risk are not reflected in the calculation of the firm’s equity capital Yet changes

in the market value of assets and liabilities and hence changes in the market value ofequity capital are what indicate if a firm is truly insolvent Furthermore, it is the mar-ket value of capital that determines the incentives for a bank to hold risky assets.Market-value accounting when calculating capital requirements is another reformthat receives substantial support All assets and liabilities could be updated to marketvalue periodically—say, every three months—to determine if a bank’s capital is suffi-cient to meet the minimum requirements This market-value accounting informationwould let the deposit insurance agency know quickly when a bank was falling belowits capital requirement The bank could then be closed down before its net worth fellbelow zero, thus preventing a loss to the deposit insurance agency The market-value-based capital requirement would also ensure that banks would not be operating withnegative capital, thereby preventing the bet-the-bank strategy of taking on excessiverisk

Objections to market-value-based capital requirements center on the difficulty ofmaking accurate and straightforward market-value estimates of capital Historical-costaccounting has an important advantage in that accounting rules are easier to defineand standardize when the value of an asset is simply set at its purchase price Market-value accounting, by contrast, requires estimates and approximations that are harder

to standardize For example, it might be hard to assess the market value of your friendJoe’s car loan, whereas it would be quite easy to value a government bond In addi-tion, conducting market-value accounting would prove costly to banks because esti-mation of market values requires the collection of more information about thecharacteristics of assets and liabilities Nevertheless, proponents of market-valueaccounting for capital requirements point out that although market-value accountinginvolves some estimates and approximations, it would still provide regulators withmore accurate assessment of bank equity capital than historical-cost accounting does

FDICIA appears to be an important step in the right direction, because it increases theincentives for banks to hold capital and decreases their incentives to take on exces-sive risk However, more could be done to improve the incentives for banks to limittheir risk taking Yet eliminating deposit insurance and the too-big-to-fail policy alto-gether may be going too far, because these proposals might make the banking systemtoo prone to a banking panic

Overall Evaluation

PREVIEW Banking is not the only type of financial intermediation you are likely to experience.

You might decide to purchase insurance, take out an installment loan from a financecompany, or buy a share of stock In each of these transactions you will be engaged

in nonbank finance and will deal with nonbank financial institutions In our economy,nonbank finance also plays an important role in channeling funds from lender-savers

to borrower-spenders Furthermore, the process of financial innovation we discussed

in Chapter 10 has increased the importance of nonbank finance and is blurring thedistinction between different financial institutons This chapter examines in moredetail how institutions engaged in nonbank finance operate, how they are regulated,and recent trends in nonbank finance

a result of accidents, fire, or theft

The first life insurance company in the United States (Presbyterian Ministers’ Fund inPhiladelphia) was established in 1759 and is still in existence There are currentlyabout 1,400 life insurance companies, which are organized in two forms: as stockcompanies or as mutuals Stock companies are owned by stockholders; mutuals aretechnically owned by the policyholders Although over 90% of life insurance compa-nies are organized as stock companies, some of the largest ones are organized asmutuals

Unlike commercial banks and other depository institutions, life insurance panies have never experienced widespread failures, so the federal government has notseen the need to regulate the industry Instead, regulation is left to the states in which

com-a compcom-any opercom-ates Stcom-ate regulcom-ation is directed com-at scom-ales prcom-actices, the provision of

The Insurance Information

Institute publishes facts and

statistics about the

insurance industry

adequate liquid assets to cover losses, and restrictions on the amount of risky assets(such as common stock) that the companies can hold The regulatory authority is typ-ically a state insurance commissioner.

Because death rates for the population as a whole are predictable with a highdegree of certainty, life insurance companies can accurately predict what their payouts

to policyholders will be in the future Consequently, they hold long-term assets thatare not particularly liquid—corporate bonds and commercial mortgages as well assome corporate stock

There are two principal forms of life insurance policies: permanent life insurance(such as whole, universal, and variable life) and temporary insurance (such as term).Permanent life insurance policies have a constant premium throughout the life of thepolicy In the early years of the policy, the size of this premium exceeds the amountneeded to insure against death because the probability of death is low Thus the pol-icy builds up a cash value in its early years, but in later years the cash value declinesbecause the constant premium falls below the amount needed to insure against death,the probability of which is now higher The policyholder can borrow against the cashvalue of the permanent life policy or can claim it by canceling the policy

Term insurance, by contrast, has a premium that is matched every year to theamount needed to insure against death during the period of the term (such as oneyear or five years) As a result, term policies have premiums that rise over time as theprobability of death rises (or level premiums with a decline in the amount of deathbenefits) Term policies have no cash value and thus, in contrast to permanent lifepolicies, provide insurance only, with no savings aspect

Weak investment returns on permanent life insurance in the 1960s and 1970s led

to slow growth of demand for life insurance products The result was a shrinkage inthe size of the life insurance industry relative to other financial intermediaries, withtheir share of total financial intermediary assets falling from 19.6% at the end of 1960

to 11.5% at the end of 1980 (See Table 1, which shows the relative shares of financialintermediary assets for each of the financial intermediaries discussed in this chapter.)Beginning in the mid-1970s, life insurance companies began to restructure theirbusiness to become managers of assets for pension funds An important factor behindthis restructuring was 1974 legislation that encouraged pension funds to turn fundmanagement over to life insurance companies Now more than half of the assets man-aged by life insurance companies are for pension funds and not for life insurance.Insurance companies have also begun to sell investment vehicles for retirement such

as annuities, arrangements whereby the customer pays an annual premium in

exchange for a future stream of annual payments beginning at a set age, say 65, andcontinuing until death The result of this new business has been that the market share

of life insurance companies as a percentage of total financial intermediary assets hasheld steady since 1980

There are on the order of 3,000 property and casualty insurance companies in theUnited States, the two largest of which are State Farm and Allstate Property and casu-alty companies are organized as both stock and mutual companies and are regulated

by the states in which they operate

Although property and casualty insurance companies had a slight increase intheir share of total financial intermediary assets from 1960 to 1990 (see Table 1), inrecent years they have not fared well, and insurance premiums have skyrocketed.With the high interest rates in the 1970s and 1980s, insurance companies had high

The Flow of Funds Accounts of

the United States reports details

about the current state of the

insurance industry Scroll down

through the table of contents to

find the location of data on

insurance companies

investment income that enabled them to keep insurance rates low Since then, ever, investment income has fallen with the decline in interest rates, while the growth

how-in lawsuits how-involvhow-ing property and casualty how-insurance and the explosion how-in amountsawarded in such cases have produced substantial losses for companies

To return to profitability, insurance companies have raised their rates cally—sometimes doubling or even tripling premiums—and have refused to providecoverage for some people They have also campaigned actively for limits on insurancepayouts, particularly for medical malpractice In the search for profits, insurance com-panies are also branching out into uncharted territory by insuring the payment ofinterest on municipal and corporate bonds and on mortgage-backed securities Oneworry is that the insurance companies may be taking on excessive risk in order toboost their profits One result of the concern about the health of the property andcasualty insurance industry is that insurance regulators have proposed new rules thatwould impose risk-based capital requirements on these companies based on the risk-iness of their assets and operations

dramati-The investment policies of these companies are affected by two basic facts First,because they are subject to federal income taxes, the largest share of their assets is held

in tax-exempt municipal bonds Second, because property losses are more uncertainthan the death rate in a population, these insurers are less able to predict how muchthey will have to pay policyholders than life insurance companies are Natural or

unnatural disasters such as the Los Angeles earthquake in 1994 and Hurricane Floyd

in 1999, which devastated parts of the East Coast, and the September 11, 2001destruction of the World Trade Center, exposed the property and casualty insurancecompanies to billions of dollars of losses Therefore, property and casualty insurancecompanies hold more liquid assets than life insurance companies; municipal bondsand U.S government securities amount to over half their assets, and most of theremainder is held in corporate bonds and corporate stock

Property and casualty insurance companies will insure against losses from almostany type of event, including fire, theft, negligence, malpractice, earthquakes, andautomobile accidents If a possible loss being insured is too large for any one firm,several firms may join together to write a policy in order to share the risk Insurance

companies may also reduce their risk exposure by obtaining reinsurance Reinsurance

allocates a portion of the risk to another company in exchange for a portion of thepremium and is particularly important for small insurance companies You can think

of reinsurance as insurance for the insurance company The most famous risk-sharingoperation is Lloyd’s of London, an association in which different insurance companiescan underwrite a fraction of an insurance policy Lloyd’s of London has claimed that

it will insure against any contingency—for a price

Until recently, banks have been restricted in their ability to sell life insurance ucts This has been changing rapidly, however Over two-thirds of the states allowbanks to sell life insurance in one form or another In recent years, the bank regula-tory authorities, particularly the Office of the Comptroller of the Currency (OCC),have also encouraged banks to enter the insurance field because getting into insur-ance would help diversify banks’ business, thereby improving their economic healthand making bank failures less likely For example, in 1990, the OCC ruled that sell-ing annuities was a form of investment that was incidental to the banking businessand so was a permissible banking activity As a result, the banks’ share of the annu-ities market has surpassed 20% Currently, more than 40% of banks sell insuranceproducts, and the number is expected to grow in the future

prod-Insurance companies and their agents reacted to this competitive threat with bothlawsuits and lobbying actions to block banks from entering the insurance business.Their efforts were set back by several Supreme Court rulings that favored the banks.Particularly important was a ruling in favor of Barnett Bank in March 1996, which heldthat state laws to prevent banks from selling insurance can be superseded by federalrulings from banking regulators that allow banks to sell insurance The decision gavebanks a green light to further their insurance activities, and with the passage of theGramm-Leach-Bliley Act of 1999, banking institutions will further engage in the insur-ance business, thus blurring the distinction between insurance companies and banks

trans-agents) If the insurer’s production process of asset transformation efficientlyprovides its customers with adequate insurance services at low cost and if itcan earn high returns on its investments, it will make profits; if not, it willsuffer losses.

In Chapter 9 the economic concepts of adverse selection and moral ard allowed us to understand principles of bank management related to man-aging credit risk; many of these same principles also apply to the lendingactivities of insurers Here again we apply the adverse selection and moral haz-ard concepts to explain many management practices specific to insurance

haz-In the case of an insurance policy, moral hazard arises when the existence

of insurance encourages the insured party to take risks that increase the lihood of an insurance payoff For example, a person covered by burglaryinsurance might not take as many precautions to prevent a burglary becausethe insurance company will reimburse most of the losses if a theft occurs

like-Adverse selection holds that the people most likely to receive large insurancepayoffs are the ones who will want to purchase insurance the most Forexample, a person suffering from a terminal disease would want to take outthe biggest life and medical insurance policies possible, thereby exposing theinsurance company to potentially large losses Both adverse selection andmoral hazard can result in large losses to insurance companies, because theylead to higher payouts on insurance claims Lowering adverse selection andmoral hazard to reduce these payouts is therefore an extremely importantgoal for insurance companies, and this goal explains the insurance practices

we will discuss here

To reduce adverse selection, insurance providers try to screen out good ance risks from poor ones Effective information collection procedures aretherefore an important principle of insurance management

insur-When you apply for auto insurance, the first thing your insurance agentdoes is ask you questions about your driving record (number of speedingtickets and accidents), the type of car you are insuring, and certain personalmatters (age, marital status) If you are applying for life insurance, you gothrough a similar grilling, but you are asked even more personal questionsabout such things as your health, smoking habits, and drug and alcohol use

The life insurer even orders a medical evaluation (usually done by an pendent company) that involves taking blood and urine samples Just as abank calculates a credit score to evaluate a potential borrower, the insurersuse the information you provide to allocate you to a risk class—a statisticalestimate of how likely you are to have an insurance claim Based on thisinformation, the insurer can decide whether to accept you for the insurance

inde-or to turn you down because you pose too high a risk and thus would be anunprofitable customer

Charging insurance premiums on the basis of how much risk a policyholderposes for the insurance provider is a time-honored principle of insurancemanagement Adverse selection explains why this principle is so important

to insurance company profitability

Risk-Based

Premiums

Screening

To understand why an insurance provider finds it necessary to have based premiums, let’s examine an example of risk-based insurance premiumsthat at first glance seems unfair Harry and Sally, both college students with noaccidents or speeding tickets, apply for auto insurance Normally, Harry will

risk-be charged a much higher premium than Sally Insurance providers do thisbecause young males have a much higher accident rate than young females.Suppose, though, that one insurer did not base its premiums on a risk classi-fication but rather just charged a premium based on the average combinedrisk for males and females Then Sally would be charged too much and Harrytoo little Sally could go to another insurer and get a lower rate, while Harrywould sign up for the insurance Because Harry’s premium isn’t high enough

to cover the accidents he is likely to have, on average the insurer would losemoney on Harry Only with a premium based on a risk classification, so thatHarry is charged more, can the insurance provider make a profit.1

Restrictive provisions in policies are an insurance management tool forreducing moral hazard Such provisions discourage policyholders fromengaging in risky activities that make an insurance claim more likely Forexample, life insurers have provisions in their policies that eliminate deathbenefits if the insured person commits suicide within the first two years thatthe policy is in effect Restrictive provisions may also require certain behav-ior on the part of the insured A company renting motor scooters may berequired to provide helmets for renters in order to be covered for any liabil-ity associated with the rental The role of restrictive provisions is not unlikethat of restrictive covenants on debt contracts described in Chapter 8: Bothserve to reduce moral hazard by ruling out undesirable behavior

Insurance providers also face moral hazard because an insured person has anincentive to lie to the insurer and seek a claim even if the claim is not valid.For example, a person who has not complied with the restrictive provisions

of an insurance contract may still submit a claim Even worse, a person mayfile claims for events that did not actually occur Thus an important manage-ment principle for insurance providers is conducting investigations to pre-vent fraud so that only policyholders with valid claims receive compensation

Being prepared to cancel policies is another insurance management tool.Insurers can discourage moral hazard by threatening to cancel a policy whenthe insured person engages in activities that make a claim more likely If yourauto insurance company makes it clear that coverage will be canceled if adriver gets too many speeding tickets, you will be less likely to speed

The deductible is the fixed amount by which the insured’s loss is reduced

when a claim is paid off A $250 deductible on an auto policy, for example,

helps insurance providers reduce moral hazard With a deductible, you rience a loss along with the insurer when you make a claim Because you alsostand to lose when you have an accident, you have an incentive to drive morecarefully A deductible thus makes a policyholder act more in line with what

expe-is profitable for the insurer; moral hazard has been reduced And becausemoral hazard has been reduced, the insurance provider can lower the pre-mium by more than enough to compensate the policyholder for the existence

of the deductible Another function of the deductible is to eliminate theadministrative costs of handling small claims by forcing the insured to bearthese losses

When a policyholder shares a percentage of the losses along with the insurer,

their arrangement is called coinsurance For example, some medical

insur-ance plans provide coverage for 80% of medical bills, and the insured personpays 20% after a certain deductible has been met Coinsurance works toreduce moral hazard in exactly the same way that a deductible does A policy-holder who suffers a loss along with the insurer has less incentive to takeactions, such as going to the doctor unnecessarily, that involve higher claims

Coinsurance is thus another useful management tool for insurance providers

Another important principle of insurance management is that there should

be limits on the amount of insurance provided, even though a customer iswilling to pay for more coverage The higher the insurance coverage, themore the insured person can gain from risky activities that make an insur-ance payoff more likely and hence the greater the moral hazard For exam-ple, if Zelda’s car were insured for more than its true value, she might nottake proper precautions to prevent its theft, such as making sure that thekey is always removed or putting in an alarm system If it were stolen, shecomes out ahead because the excessive insurance payment would allow her

to buy an even better car By contrast, when the insurance payments arelower than the value of her car, she will suffer a loss if it is stolen and willthus take precautions to prevent this from happening Insurance providersmust always make sure that their coverage is not so high that moral hazardleads to large losses

Effective insurance management requires several practices: information lection and screening of potential policyholders, risk-based premiums, restric-tive provisions, prevention of fraud, cancellation of insurance, deductibles,coinsurance, and limits on the amount of insurance All of these practicesreduce moral hazard and adverse selection by making it harder for policy-holders to benefit from engaging in activities that increase the amount andlikelihood of claims With smaller benefits available, the poor insurance risks(those who are more likely to engage in the activities in the first place) seeless benefit from the insurance and are thus less likely to seek it out

Pension Funds

In performing the financial intermediation function of asset transformation, pensionfunds provide the public with another kind of protection: income payments onretirement Employers, unions, or private individuals can set up pension plans,which acquire funds through contributions paid in by the plan’s participants As wecan see in Table 1, pension plans both public and private have grown in importance,with their share of total financial intermediary assets rising from 10% at the end of

1960 to 22.6% at the end of 2002 Federal tax policy has been a major factor behindthe rapid growth of pension funds because employer contributions to employee pen-sion plans are tax-deductible Furthermore, tax policy has also encouraged employeecontributions to pension funds by making them tax-deductible as well and enablingself-employed individuals to open up their own tax-sheltered pension plans, Keoghplans, and individual retirement accounts (IRAs)

Because the benefits paid out of the pension fund each year are highly dictable, pension funds invest in long-term securities, with the bulk of their assetholdings in bonds, stocks, and long-term mortgages The key management issues forpension funds revolve around asset management: Pension fund managers try to holdassets with high expected returns and lower risk through diversification They alsouse techniques we discussed in Chapter 9 to manage credit and interest-rate risk.The investment strategies of pension plans have changed radically over time In theaftermath of World War II, most pension fund assets were held in governmentbonds, with less than 1% held in stock However, the strong performance of stocks

pre-in the 1950s and 1960s afforded pension plans higher returns, causpre-ing them to shifttheir portfolios into stocks, currently on the order of two-thirds of their assets As aresult, pension plans now have a much stronger presence in the stock market: In theearly 1950s, they held on the order of 1% of corporate stock outstanding; currentlythey hold on the order of 25% Pension funds are now the dominant players in thestock market

Although the purpose of all pension plans is the same, they can differ in a ber of attributes First is the method by which payments are made: If the benefits aredetermined by the contributions into the plan and their earnings, the pension is a

num-defined-contribution plan; if future income payments (benefits) are set in advance,

the pension is a defined-benefit plan In the case of a defined-benefit plan, a further attribute is related to how the plan is funded A defined-benefit plan is fully funded

if the contributions into the plan and their earnings over the years are sufficient to payout the defined benefits when they come due If the contributions and earnings are

not sufficient, the plan is underfunded For example, if Jane Brown contributes $100

per year into her pension plan and the interest rate is 10%, after ten years the tributions and their earnings would be worth $1,753.2If the defined benefit on her

con-2 The $100 contributed in year 1 would become worth $100  (1  0.10) 10  $259.37 at the end of ten years; the $100 contributed in year 2 would become worth $100  (1  0.10) 9  $235.79; and so on until the $100 contributed in year 10 would become worth $100  (1  0.10)  $110 Adding these together, we get the total value of these contributions and their earnings at the end of ten years:

$259.37  $235.79  $214.36  $194.87  $177.16

 $161.05  $146.41  $133.10  $121.00  $110.00  $1,753.11

benefit is $2,000, the plan is underfunded, because her contributions and earnings

do not cover this amount

A second characteristic of pension plans is their vesting, the length of time that a

person must be enrolled in the pension plan (by being a member of a union or anemployee of a company) before being entitled to receive benefits Typically, firms requirethat an employee work five years for the company before being vested and qualifying toreceive pension benefits; if the employee leaves the firm before the five years are up,either by quitting or being fired, all rights to benefits are lost

Private pension plans are administered by a bank, a life insurance company, or a sion fund manager In employer-sponsored pension plans, contributions are usuallyshared between employer and employee Many companies’ pension plans are under-funded because they plan to meet their pension obligations out of current earningswhen the benefits come due As long as companies have sufficient earnings, under-funding creates no problems, but if not, they may not be able to meet their pensionobligations Because of potential problems caused by corporate underfunding, mis-management, fraudulent practices, and other abuses of private pension funds(Teamsters pension funds are notorious in this regard), Congress enacted the EmployeeRetirement Income Security Act (ERISA) in 1974 This act established minimum stan-dards for the reporting and disclosure of information, set rules for vesting and thedegree of underfunding, placed restrictions on investment practices, and assigned theresponsibility of regulatory oversight to the Department of Labor

pen-ERISA also created the Pension Benefit Guarantee Corporation (called “PennyBenny”), which performs a role similar to that of the FDIC It insures pension bene-fits up to a limit (currently over $40,000 per year per person) if a company with anunderfunded pension plan goes bankrupt or is unable to meet its pension obligationsfor other reasons Penny Benny charges pension plans premiums to pay for this insur-ance, and it can also borrow funds up to $100 million from the U.S Treasury.Unfortunately, the problem of pension plan underfunding has been growing worse inrecent years In 1993, the secretary of labor indicated that underfunding had reachedlevels in excess of $45 billion, with one company’s pension plan alone, that of GeneralMotors, underfunded to the tune of $11.8 billion As a result, Penny Benny, whichinsures the pensions of one of every three workers, may have to foot the bill if com-panies with large underfunded pensions go broke

The most important public pension plan is Social Security (Old Age and Survivors’Insurance Fund), which covers virtually all individuals employed in the private sector.Funds are obtained from workers through Federal Insurance Contribution Act (FICA)deductions from their paychecks and from employers through payroll taxes SocialSecurity benefits include retirement income, Medicare payments, and aid to the disabled.When Social Security was established in 1935, the federal government intended tooperate it like a private pension fund However, unlike a private pension plan, bene-fits are typically paid out from current contributions, not tied closely to a participant’spast contributions This “pay as you go” system at one point led to a massive under-funding, estimated at over $1 trillion

The problems of the Social Security system could become worse in the futurebecause of the growth in the number of retired people relative to the working

contains information on your

benefits available from social

security.

www.pbgc.gov/

The web site for the Pension

Benefit Guarantee Corporation

contains information about

pensions and the insurance that

it provides.