The Region

FDIC Reform: Use the Market to Monitor Big Banks

Guest Editorial: Chris Farrell, BusinessWeek writer and TV and radio host, discusses the need for federal deposit insurance reform.

Chris Farrell | Contributing Economics Editor, BusinessWeek

Published June 1, 2000  | June 2000 issue

If large depositors bore some risk, they would help check recklessness at "too-big-to-fail" banks

All eyes are on the stock market these days for a simple reason: The volatility is stunning. The Wilshire 5000 index rose in value by $1 trillion, to a record $14.8 trillion, from the beginning of the year—only to lose more than $1.5 trillion in value over the past month. Similarly, the NASDAQ rose by 20 percent from early this year to its March peak, only to drop by more than 30 percent since then. Many investors are getting an object lesson in market risk these days.

In this whirlwind, one source of long-term financial risk has received short shrift—and the trend is worrisome. Debt growth is surging at a nearly double-digit pace, after adjusting for inflation. Indeed, except for a brief period in the mid-1980s, this is the strongest rate of borrowing in 40 years, says Mark Zandi, economist at Regional Financial Associates Inc. High leverage often exacerbates an economic downturn, as consumers and businesses worry about meeting their debt payments. Given this surge in borrowing, policymakers should seriously address the issue of federal deposit insurance reform. Now, when the economy is strong, is the time to minimize the financial stress that will accompany the next recession.

The role of federal deposit insurance is to prevent bank panics and maintain financial stability during troubled economic times. The system has been remarkably successful since it was signed into law some 66 years ago. But banks are getting bigger as the industry consolidates. In 1980, banks with assets greater than $10 billion controlled 37 percent of total bank assets. In 1998, the comparable figure was 63 percent. And the trend toward consolidation is widely expected to accelerate following enactment last year of a massive banking-reform measure, which eliminates the traditional barriers between banking, insurance and securities underwriting.

The bigger they are ...

For instance New York based Citigroup, the world's largest financial firm, has $739 billion in assets, more than 100 million customers in 100 countries, and offers one-stop shopping for banking, insurance, investments, credit cards and more. Bank of America Corp., created by the 1998 merger between BankAmerica and Nationsbank, isn't all that far behind. It has $570 billion in assets, branches in 22 states and 40 foreign countries, and also offers a broad array of financial services.

Policymakers now consider many of the new regional, national and global megabanks "too big to fail." All depositors at these institutions are protected from losing money if their bank becomes insolvent. That's because regulators are afraid to take the chance of sparking a financial panic and economic collapse if they enforced the current $100,000 insurance deposit limit (something they are perfectly willing to do at a community bank). And the striking trend toward consolidation suggests that the number of too-big-to-fail banks will grow in coming years.

The danger haunting regulators is that the too-big-to-fail doctrine will eventually encourage reckless behavior at financial-services giants during boom times—like now. Why shouldn't management take reckless risks? After all, if the financial gambles pay off, stockholders, including option-laden executives, will pocket huge profits. But if they lose the bets when the economy tanks, taxpayers will pick up the tab. This disastrous dynamic was at work during the 1980s savings-and-loan crisis.

Market incentive

At a time of quicksilver technological change and rapid financial innovation, traditional government regulation isn't an efficient way to forestall trouble. Besides, the nation's Balkanized regulatory structure is already struggling to keep up with aggressive and imaginative financiers. Instead, policymakers should harness the power of the market to better monitor bank management. Keep the $100,000 federal deposit insurance for individuals. But put larger, more sophisticated depositors at moderate financial risk so that they have an incentive to monitor their banks.

For example, the Federal Reserve Bank of Minneapolis proposes that large-scale uninsured depositors and creditors could lose up to 20 percent of their funds if a bank becomes insolvent. The loss would be painful—but not enough to set off a bank panic or a financial collapse. And the risk of losing money would create a powerful incentive for large, sophisticated depositors to closely watch their banks. Corporate treasurers, foundation executives and other large depositors would also start demanding additional financial disclosure and openness so that they could make more informed judgments. "With increased incentive for large depositors to monitor the quality of banks, the risk premiums found in the rates charged by such depositors and other creditors put at risk should provide a more accurate reading on bank risk than currently exists," says Gary Stern, head of the Minneapolis Fed.

Another market-based regulatory proposal is to require banks to issue publicly traded subordinated debt. These debt holders come only before equity holders in making a claim on bank assets and so would be at considerable monetary risk if their bank becomes insolvent. Again, they would have an incentive to keep a close eye on management. Federal deposit insurance reform isn't part of the current policy debate. But it should be, for the sake of the economy's long-term stability.

Farrell's commentary first appeared in the May 12, 2000, issue of BusinessWeek Online.

Chris Farrell
Chris Farrell is contributing economics editor for BusinessWeek and writes for BW Online every Friday. He is also chief economics correspondent at Minnesota Public Radio and host of MPR's weekly Sound Money program and public television's weekly Right on the Money. Both programs are broadcast nationally. Previously, Farrell was finance editor at Business Times on ESPN and was heard on Business Times Radio.

He holds degrees from the London School of Economics and Stanford University.