A Modest Proposal for Meaningful Deposit Insurance Reform

Last December, in these pages, I announced my intention to reinvestigate the issue of deposit insurance reform, and indicated that this bank would form an advisory committee of Ninth District bankers to discuss the issue. That effort was completed this summer, along with a resultant policy proposal.

And even though my original hope was to find some consensus among the bankers, it is safe to say that the proposal did not meet with the unanimous opinion of the committee. However, that difference of opinion came as no surprise. The very idea of tinkering with deposit insurance, even in the smallest way, is considered unwise—at best—by some in the industry, while others would propose nothing short of a radical reformation. Our proposal lies somewhere in between and, I would argue, tends toward a more modest reform because it actually builds on existing legislation. But before I describe the proposal, let me first explain why we decided to address deposit insurance reform now, and also tell you about the process we used to explore the issue.

The idea of deposit insurance reform is nothing new to the banking industry, nor to this bank. In addition to research begun in the 1970s by economists at the Minneapolis Fed, this bank also called for reform of deposit insurance in its 1988 Annual Report, a time when the banking industry was reeling from a record number of failures in the post-Depression era. Why, then, are we reintroducing the subject now, at a time of relative calm and prosperity within the banking industry? Precisely because it is so. A favorable environment is best for a dispassionate investigation of such an important issue.

But perhaps more importantly, why wait for another crisis when we can try to prevent it? The severe problems experienced in the 1980s occurred at a time when regulators were concerned that the loss of just one large bank could have systemic implications. Today, that is even more cause for concern. Banks are even larger and more complicated now; in addition, there are a greater number of large banks that, with the concomitant drop in the total number of institutions, hold a larger percentage of the industry's deposits. Hence, the health of just one of these big banks is vital to the health of the entire financial system. Also, these large banks have acquired more banking powers since the 1980s and are asking for even more, which, if nothing else, will extend the scope of the government safety net and, likewise, taxpayer exposure.

So, the time being right to discuss deposit insurance reform, we decided to seek the counsel of representative bankers from across our district—from small to large banks and from rural to urban locations. The bankers in attendance are noted on these pages; they were of strong opinion and, as I indicated earlier, were not necessarily in favor of our proposal. But their input—which included two meetings, correspondence and phone conversations—was valuable nonetheless and helped shape the final proposal. We would like to extend our thanks to those bankers for their time and energy on this important matter.

Briefly, our proposal recommends that uninsured depositors—those with more than $100,000 in a bank account—should face some risk, thereby causing those depositors to put pressure on banks to operate in a more safe and sound manner. This proposal, in effect, builds on existing banking legislation that was passed, in part, to resolve this issue but that fell short of achieving a solution. In particular, our proposal addresses the issue of moral hazard, the term referring to the costly side effect of a de facto full insurance program: Depositors and banks have an incentive to take on more risk than they otherwise would. If depositors are subjected to a limited but meaningful loss, the market for information about the financial condition of banks will certainly broaden and deepen over time, and, it follows, so will banks' commitment to safe and sound banking practices.

I won't take the time to lay out the further specifics of the plan in this space, rather, I invite you to read the full proposal found inside this magazine. Some of you may be familiar with elements of our proposal, as an excerpted version was recently featured in The Wall Street Journal, and The American Banker has written articles based on our ideas. I should also note that our 1997 Annual Report, due in spring of next year, will present a more detailed analysis of the issues surrounding this proposal, such as the effectiveness of the 1991 Federal Deposit Insurance Corp. Improvement Act, the question of uninsured creditors and other considerations.

The time is right for a serious review of deposit insurance, and I think our proposal, in addressing the issue of moral hazard, is a necessary step toward meaningful reform.

Deposit Insurance Reform: An Advisory Committee

The following bankers attended the meetings held at the Federal Reserve Bank of Minneapolis on the issue of deposit insurance reform. They brought divergent views to the table, many of which were in opposition to reform, others favored a more radical reform than the one proposed by the bank, while a distinct minority fell between those opposing views.