What is 'Modified Payoff'

A modified payoff is a partial insurance reimbursement that is paid to depositors of failed banks. Customers who have lost money in excess of what is covered by FDIC insurance can expect to receive a modified payoff. The payoff is based on an FDIC estimate of what they could collect from liquidation.

BREAKING DOWN 'Modified Payoff'

The FDIC instituted the modified payoff in the early 1980s. It was offered in response to a rash of bank failures that led to substantial customer losses.

Under the proposed FDIC ''modified payout program,'' depositors in a failed bank received up to the first $100,000, but those with funds not covered by insurance and other creditors would get a cash advance based on an estimate of what will be recovered from the failed bank's assets. If assets proved to be more valuable than estimates, these creditors would receive an additional payment.

Because the risk is high that creditors and uninsured depositors would lose money if a bank failed, modified payoff policies would increase the incentive for depositors to choose a bank based on its strength, rather than solely an offered interest rate.

The FDIC was advised to move forward with modified payoff policy because market discipline was seen as an essential ingredient of deregulation. The thought was that such a policy would impose market discipline on banks by virtue of their depositors understanding that they could lose their money.

Some state governments supplemented FDIC modified payoffs with state funds to ensure that depositors come out whole, even where institutions were not covered.

Abandonment of Modified Payoff Policies

Modified payoff policies were abandoned following the case of the failure of the Continental Illinois bank. The Continental Illinois National Bank and Trust Company was at one time the seventh-largest commercial bank in the United States as measured by deposits, with approximately $40 billion in assets. In 1984, Continental Illinois became the largest ever bank failure in U.S. history, when a run on the bank led to its seizure by the Federal Deposit Insurance Corporation (FDIC). Continental Illinois was the largest bank failure in the United States until the fall of Washington Mutual in 2008, during the financial crisis of 2008. Washington Mutual was over seven times larger than the failure of Continental Illinois.

Rationale for abandoning modified payoffs dealt mostly with the policy's demonstrated propensity to protect the creditors of large institutions more than those of small institutions. This not only removed an important source of market discipline on the risk-taking propensities of management, but also instituted a system of differential guarantees, in which large institutions were favored over smaller institutions. It was reasoned that differential coverage conveyed a subsidy to larger institutions, since their costs were not increased to cover their increased coverage. These policies also raised a fairness issue, since large institutions were given a competitive advantage over small firms by virtue of their better guarantees.

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