This memorandum constitutes the joint response of the Division of Insurance and Research and the Division of Supervision and Consumer Protection to your Draft Report Entitled, Consideration of Safety and Soundness Examination Results and Other Relevant Information in the FDIC’s Risk-Related Premium System (Assignment No. 2005-033). We are pleased that you found that we “appropriately assessed the institutions’ conditions and ratings,” that “Supervisory Subgroups were adequately tied to results of examinations,” and that we communicated with other primary regulators regarding Supervisory Subgroup assignments. Our response follows the report’s recommendations, which we reproduce.

OIG Recommendation

1. We recommend that the Director, DIR, pursue revisions to Part 327 and related implementing procedures to permit Capital Group adjustments during the RRPS process when capital Is Impaired based on CAMELS ratings and related supervisory concerns.

DIR concurs in part and offers an alternative.

We continue to believe that the Board’s decision to use both subjective factors (CAMELS composite ratings) and objective factors (capital ratios) when it created the assessment risk categories was correct. An institution always has an incentive to maintain its capital ratios at the level required to be considered well capitalized for assessment purposes and always has an incentive to improve its CAMELS composite rating to at least a 2.

We also believe that the current system already takes into account particular capital requirements that bank regulators may impose. Capital is the “C” component of the CAMELS rating and, therefore, is taken into account when the composite rating is computed. Thus, an institution that meets the requirements to be considered well capitalized for assessment purposes, but fails to meet special capital requirements imposed by its primary federal regulator, will, in most cases, receive a lower CAMELS composite rating than it otherwise would.

However, we do agree that the present assessment system may at times be slow to respond to subsequent events.^{[ 1 ]} DIR is considering improvements to the assessment system that would:

• Evaluate an institution’s capital levels quarterly, rather than semiannually, as at present.using the existing objective capital definitions; and

• Reflect changes in CAMELS composite ratings more frequently than semiannually, as at present.

DIR envisions that these improvements to the assessment system would be brought to the Board in conjunction with changes brought about by pending deposit insurance reform legislation. However, in the event that this legislation does not pass, DIR still intends to consider similar changes by year-end 2006.

OIG Recommendations

We recommend the Director, DIR:

2. Update the analysis supporting the basis point rate spreads applied to the assessment rate matrix for the deposit insurance funds.

3. Present the updated analysis as part of the assessment rate cases to the Board with recommendations for assessment rates for financial institutions based on their assessment risk classification.

4. Establish a schedule for periodically updating the assessment rate analysis and reassessing the basis point spreads and assessment rates, as needed.

DIR, concurs in part on (2) and (3) and offers an alternative to (4).

DIR has been examining a possible update to assessment rates for some time, but has not recommended that the Board change assessment rates for several reasons. There are both legal and practical limitations on our ability to construct a rate schedule that is always actuarially accurate. ^{[ 2 ]}

First, the Deposit Insurance Funds Act of 1996 prevents the FDIC from charging an institution in the 1A risk category for deposit insurance, so long as the institution’s deposit insurance fund is at or above the designated reserve ratio (DRR), 1.25 percent, and is expected to remain so. Since 1995, at least 90 percent of institutions have been in this category; at present 94 percent of institutions are in this category. Collectively these institutions currently account for more than 98 percent of the assessment base. Of course, every institution poses some risk, so these institutions are not being charged—and cannot be charged, under existing law—actuarially accurate assessments.

In 1995, when the FDIC adopted a base assessment schedule for the Bank Insurance Fund of 4 to 31 basis points, it noted that an actuarially accurate premium spread would have been much wider than 27 basis points.^{[ 3 ]} However, the spread chosen, the Board noted, would not threaten the solvency of the riskiest banks.

Second, the assessment schedule in place over the last ten years continues to fulfill the purposes intended by the Board. Riskier institutions pay more for their deposit insurance coverage and the reserve ratios have remained at or above target levels. The assessment schedule for both funds for approximately the past ten years has been the base schedule reduced by four basis points—so that the best-rated institutions pay a zero rate, consistent with the requirements of the Funds Act, and the rate spread remains 27 basis points. Riskier institutions pay more and have an incentive to improve their risk classification.^{[ 4 ]}

Third, during the past five years, the FDIC has focused on a broader set of deposit insurance reform recommendations.

Fourth, the relatively few failures in the years since the current schedule has been in place have provided little new information to re-evaluate the spreads between rates in the assessment matrix.

Finally, during approximately the past ten years, only six to ten percent of institutions have paid deposit insurance assessments at any time.

For these reasons, the benefits of changing assessment rates were, in DIR’s opinion, outweighed by the costs and potential risks.

However, DIR does intend to propose to the Board substantial revisions to the assessment system as part of deposit insurance reform implementation (assuming reform legislation is enacted, as appears likely). DIR’s goal will be to recommend assessment rates that better reflect differences in risk among FDIC-insured institutions and are most likely to keep the fund’s reserve ratio within the range contemplated by pending reform legislation. We will achieve this goal in 2006.

It would be premature at this time to establish a schedule for periodically updating the assessment rate analysis and reassessing the basis point spreads and assessment rates. Instead, DIR proposes that considerations of the frequency of rate updates await initial implementation of assessment system changes pursuant to reform legislation. Much will depend on the outcome to the initial changes and the manner in which the Board wants to evaluate their effectiveness. The success of the new system in keeping within the statutory range for the reserve ratio will also play a role in determining the frequency of assessment rate updates.

In the event that reform legislation does not pass, DIR intends to consider possible improvements in the assessment structure within the confines of current law by year-end 2006.