Deposit insurance proposal elicits response

Independent bankers look at the Minneapolis Fed's deposit insurance reform proposal

Published January 1, 1998  | January 1998 issue

Minneapolis Fed President Gary Stern recently proposed that the nation's deposit insurance system should be reformed to help ensure that large banks operate in a more safe and sound manner, thereby safeguarding the nation's taxpayers against a possible costly bailout—the likes of which occurred following the financial troubles of the 1980s. Briefly, Stern advocates 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 perform prudently.

In response, the following column appeared in the Oct. 31 issue of Washington Weekly Report, a publication of the Independent Bankers Association of America (IBAA). One of the IBAA's members, Robert Meyerson of Atwater, Minn., then took issue with the IBAA's commentary. Both are reprinted with permission.

For more on Gary Stern's deposit insurance reform proposal, see The Region, September 1997.

View from the IBAA

Minneapolis Federal Reserve Bank President Gary Stern continues to push hard for deposit insurance reform. Fed Chairman Alan Greenspan doesn't. Dick Kovacevich of Norwest continues to use his leadership role on the Bankers Roundtable to try to fatally undermine the federal deposit insurance system that has served our country so well.

Both Gary Stern and Kovacevich get hung up on too-big-to-fail and create the appealing illusion that too-big-to-fail can be done away with, at least to the extent of putting large depositors at too-big-to-fail banks at risk. It is imperative that community bankers don't buy into illusions in this regard. In 1984, Fed Chairman Paul Volcker, Treasury Secretary Don Regan and FDIC Chairman Bill Isaac bailed out all depositors and creditors of Continental Illinois. Later in that decade, all depositors were made whole at the major Texas banks that were going down, and again in 1991 at the Bank of New England.

FDICIA reforms have made it more difficult to invoke too-big-to-fail by requiring that the FDIC resolve failing banks using the "least cost resolution" and requiring that the FDIC, the Fed and the Treasury Secretary make a specific finding of systemic risk in order to pay any uninsured depositors or creditors. But rest assured that when the failure of a large bank poses the prospect of systemic risk, the government will intervene. Preventing a systemic failure will always remain a government function and a top government priority.

Cleverly using a Paul Volcker quote, Gary Stern in his just-published article in the Minneapolis Fed's Region magazine, creates the impression that Volcker favors the reforms Stern is advocating. We don't know whether this is the case. We do know that the Volcker quote came from the forward he wrote for a Group of 30 report titled "Global Institutions: National Supervision and Systemic Risk." The report recognizes that systemic risk exists and that governments intervene when presented with systemic risk. The opening sentence of the report's Executive Summary states: "The threat of serious disruption to the international financial system may be small, but it is nonetheless a serious concern."

A key paragraph of the report reads: "Among the much larger OECD economies, France, Finland, Japan, Norway, Spain, Sweden and the United States have all experienced costly financial problems within the last ten years that were (or are being) resolved by governments at substantial budgetary cost. In almost every case, governments chose to absorb losses and stand behind the financial system, apparently in the belief that this would be less costly than dealing with the consequences if a shock were to spread to the rest of the financial system and the wider economy. Concerned by the high costs involved and the danger of spillover into the international financial system, the G-7 Heads of State have called for measures to strengthen supervision and a number of initiatives have been launched."

On every occasion, Kovacevich makes the argument that banks are forced to carry their present regulatory burden because of deposit insurance. But, as this authoritative Group of 30 report makes clear, it is the global economy and the prospect of systemic risk presented by very large financial institutions that has led the heads of state of the most important countries in the world to call for measures to strengthen supervision to get a better grip on systemic risk. In our view, the current system of federal deposit insurance, rather, is an essential tool that helps bring stability to the system by instilling confidence in it and preventing the spread of panic or contagion in a crisis.

A banker's response

As a strong supporter of the IBAA (both our banks, Atwater State Bank and State Bank of Kimball, are 50-year members), and as a participant in the two Minneapolis Fed meetings devoted to deposit insurance "reform," I read with great interest your commentary "Wolves in Sheep's Clothing." While I have mixed feelings about "reform," I think your editorial was shortsighted.

In the past I have been very critical of Gary Stern's efforts to limit deposit insurance. I reject his faith in "market discipline" for ignoring the dark side of a market which can be irrational, ill-informed, volatile and out of proportion. I believe him mistaken when he assumes that insurance deductibles are a means of instituting more responsible behavior by insureds; rather, deductibles are primarily designed to eliminate costly-to-adjust-and-defend smaller claims, and to emphasize catastrophic coverage. And, perhaps like you, I suspect that there is a bit of agency creep here when the Federal Reserve begins poaching in the province of the FDIC.

But Gary Stern's proposal has achieved one immensely important thing: It suggests a mechanism for eliminating, or at least curbing, too-big-to-fail (TBTF). You seem to argue that it is an impossible goal. I am not so sure. At a minimum there is surely a group of banks which would be TBTF under the present arrangement, but not TBTF under Stern's regime. Perhaps this can be tested. In the instances where TBTF was invoked—Continental Illinois, et al.—would the Stern haircut have worked? The long-term answer might be that Stern's proposal would have worked, and would work, until the first time it were abandoned for TBTF. In the meantime (perhaps for all time), the big banks would have lost the TBTF advantage they now enjoy.

Independent Bankers don't like TBTF because it gives the competition this advantage. They don't like Stern's haircut because it tampers with that part of the banking structure which works very well, and differentiates us from our nonbank predators. But I would like to make a reform proposal of my own. It is based on the fact that our banks are loaned up to about 90 percent loans/deposits and, in one case, are running out of assets to pledge for public funds: Raise the deposit limit (on an indexed basis) and introduce the Stern haircut. By doing so we would get both an infusion of liquidity into those banks which find it increasingly difficult to access the deposits their loan growth requires, and we would achieve a curb on the moral risk that so irks the Federal Reserve. Were the IBAA and the Fed to work together, both might benefit and, in the process, the public as well.

Robert Meyerson
Cattail Bancshares Inc.
Atwater, Minn.