The dynamics of federal deposit insurance: A feedback view of system behavior

From 1980 to 1994 the commercial banking industry was rocked by an extraordinary upsurge in the number of bank failures. During this period, over 1,600 banks closed or received FDIC assistance. The failures were so severe that basic questions about the soundness of the FDIC and the banking industry were raised. In contributing to existing research that has been conducted on the causes of bank failures, this dissertation follows the academic thread that has focused on the endogenous incentives available to bank owners and managers that are seen as the cause of most bank failures.; The purpose of this thesis was to develop a highly aggregated system dynamics model of a single commercial bank that exhibited principal-agent and moral hazard problems and to examine the feedback mechanisms underlying a set of specific policies implemented through the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). The banking model identifies bank risk as being essentially endogenous, arising from internal mechanisms such as mis-priced deposit insurance, principal-agent problems, and incentives that reward bank managers for short-term performance.; The model is subjected to exogenous shocks representing an economic downturn, a sharp increase in interest rates, and an increase in the default rates for a particular type of loan. The behavior of the principal-agent bank is then observed with the selected FDICIA policies operating (risk-based deposit insurance, suspending dividends, required re-capitalization, limiting assets and limiting liabilities) and not operating.; Findings from the structural and simulation analyses indicate that the FDICIA policies are implemented too late to produce behavioral changes that would have a positive effect on the survival of the principal-agent bank. However, the policies do cause numerical changes that result in reduced losses for the principal-agent bank, but these reductions in losses are not substantial. The analyses further indicated that compensating feedback loops limited the effectiveness of particular policies.