Deposit insurance: It's time to cage the monster
Published April 1, 1996 | April 1996 issue
Recent discussions about deposit insurance have been about merging thrift and bank charters, taxing banks to pay the debt of the Financing Corp. and finding a few million dollars in the fantasy world of budget scoring to reduce the federal deficit. In short, recent discussions about deposit insurance have been about almost everything except deposit insurance. A deposit insurance system that began as a modest program to protect small savers from losing their savings when their bank failed has become a monster. It is now required to raise money to reduce the federal budget deficit and to pay for systemic breakdowns in our nation's economy. The magnitude of its theoretical obligations is used to justify restrictions on the products banks may offer and to impose regulations that micromanage bank activities .
The deposit insurance system is indeed a monster and it is a monster that threatens to devour the very system it is intended to protect. The larger its responsibilities become, the more intrusive become the regulations put forth to protect it. The more intrusive the regulations to protect it become, the more likely it is that it will be required to pay for the failure of institutions that cannot compete in the over-regulated environment it nourishes. It is a vicious circle. But the consequence of such a system should not be surprising.
What is the inevitable consequence of a government program that guarantees the obligations of a business? It is an overkill of regulations intended to protect the government from having to pay on its guaranty. The broader the guaranty, the more pervasive the regulation. And the more pervasive the regulation, the less competitive the regulated business becomes. Thus, the idea of "too-big-to-fail" government-sponsored deposit insurance is antithetical to the long-term health of the system it purports to protect. Paradoxically, the larger the burden the deposit insurance system is asked to bear, the more likely it becomes that it will have to bear it.
Banks, bank customers, the American economy and taxpayers would all be better off if we asked less of the deposit insurance system and if banks themselves assumed responsibility for underwriting a less ambitious deposit insurance program. The Federal Deposit Insurance Corp. (FDIC) should be owned by the banks it insures. It should be privatized.
For banks, privatizing the FDIC would eliminate the need for intrusive regulation justified by the current open-ended "too-big-to-fail" coverage of the government's insurance program. For bank customers, privatizing the FDIC would allow banks to become full-service, competitive providers of financial products and services. For the government, privatizing the FDIC would add market discipline to government regulation as the protector of depositors. Market discipline will be by far the more effective regulator. For taxpayers, privatizing the FDIC would assure that they are never again required to bail out an industry like the savings and loan industry.
There was a savings and loan crisis because sophisticated depositors knew that the deposit insurance fund, supported by the full faith and credit of the United States, would protect every depositor of every failed institution. The crisis could not have happened without "too-big-to-fail" deposit insurance. There is only one way to be sure that a savings and loan crisis never happens again and that is to eliminate the moral hazard inherent in the government-sponsored "too-big-to-fail" deposit insurance system and to require financially sophisticated owners of uninsured deposits to be at risk when they deposit their money in a bank, just as they are at risk when they invest in stocks, bonds or other financial instruments.
This article describes a plan to reform the deposit insurance system as a private corporation owned by the banks it insures. It is similar to programs operating in the insurance and brokerage industries where industry members themselves, not the government, are responsible to the customers of members who fail. The details of the plan are not as important as the principles on which it is based. A private deposit insurance program along the lines suggested below will strengthen banks, lower the cost of regulation and protect depositors and taxpayers.
Banks maintain insurance fund and provide backup guarantee for potential deposit insurance liabilities.
Under the plan, banks will be assessed as they are today to maintain the deposit insurance fund at a prescribed level. Amounts in the fund will be invested by fund managers and investment earnings used to replenish the fund to the extent necessary. Any investment earnings in excess of amounts required to maintain the fund at the prescribed level will be distributed to the contributing banks.
Instead of the current backup line of credit provided to the FDIC by the U.S. Treasury, insured banks will be required to commit $25 billion to the FDIC to replenish the fund and to pay losses in excess of fund reserves. This commitment will be an amount based on the committing bank's share of total deposits in the banking system, adjusted annually. Based on recent numbers, each bank's backup commitment would be approximately one-half of one percent of its assets. Five percent of each bank's commitment must be guaranteed by an unaffiliated institution. The willingness of other institutions to provide this guaranty and the price charged for the guaranty will provide an important market place indicator of the strength of the bank whose obligation is guaranteed.
FDIC board of directors.
The FDIC board will be composed of private sector representatives with banking experience. The exact composition of this representation and the selection process will need to be worked out. The important point is that the interface between representatives of those whose money is at risk (the insured institutions) and bank regulators will lead to more effective bank supervision and lower risk of failure.
The "too-big-to-fail" doctrine will be abolished. Deposit insurance funds will be available only to pay insured deposits. Abolishing "too-big-to-fail" will accomplish four important policy objectives. First, it will eliminate the moral hazard inherent in "too-big-to-fail." Bank managers will not be able to attract funds for imprudent purposes from depositors who rely on deposit insurance rather than prudent bank management to assure repayment. Second, it will instill market discipline as a force working along with regulation and examination to assure safe institutions. Explicitly limiting the use of deposit insurance funds to paying insured deposits will encourage depositors, particularly large depositors, to make deposits only in safe institutions. Third, all banks will be treated equally. Today small banks are allowed to fail; big banks are not. Fourth, eliminating "too-big-to-fail" will treat banks the same way other businesses are treated for purposes of managing systemic risk. The systemic risks presented by the Chrysler and Lockheed crises were assessed and dealt with by Congress on their own merits. As a policy matter, banks should be treated no differently. The availability of deposit insurance funds may well lead to the treatment of a bank failure as a systemic risk problem because of the easy availability of funds when no systemic risk exists. One wonders if the Barings Bank failure would have been treated as a systemic risk problem had it happened to a U.S. bank where regulators have easy access to "free" funds to solve any problem. How would the Drexel, Burnham and Lambert insolvency have been handled if it had been a bank? Our existing institutions have demonstrated that they are quite capable of absorbing substantial financial shocks. There is no need to continue the existence of a special shock absorber for the banking industry, particularly a shock absorber that threatens to overwhelm the industry it is supposed to protect.
FDIC ownership transferred to banks.
FDIC ownership will be turned over to insured banks in the year 2000. This delay will give time for the private funding idea to demonstrate its value and for the public to become confident that the private system will protect insured deposits.
The present deposit insurance system has strayed far from the base established by its founders. It does not work and it threatens the industry it is supposed to serve. Its incentives are perverse and it encourages imprudent behavior. Reform along the lines suggested in this article would better serve banks, their customers, the financial system and taxpayers. It is time to cage the monster.
Kovacevich is also a member of the Federal Reserve System's Federal Advisory Council.