The Region

Financial Reform's Unfinished Agenda

A Look at Deposit Insurance Funds

William M. Isaac | Chairman, The Secura Group and Secura Burnett, L.L.C and Former Chairman, Federal Deposit Insurance Corp.

Published March 1, 2000  | March 2000 issue

I believe it's time for Congress to examine the structure and function of the federal safety net and regulatory apparatus. What should be the function of deposit insurance in our modern world? What kinds of institutions should be covered by bank-type regulation and by deposit insurance? Are some too big and too complex to be included in the system? Should there be a separate system for very large and complex institutions? How can we enlist the private sector to a greater degree in reducing the moral hazard of deposit insurance?

I couldn't refuse when Gary Stern asked me to participate in this special issue of The Region dedicated to financial reform's unfinished agenda. Gary and his colleagues at the Minneapolis Fed have a
well-deserved reputation as thought leaders in the financial services industry.

I've been involved in the financial sector for over 30 years. I've been a lawyer to financial companies, a banker, a regulator and a consultant to financial institutions and governments around the world.

I served eight years on the board of directors of the FDIC (1978 through 1985), including five years as the agency's chairman (1981 through 1985). My years at the FDIC were turbulent for the financial system and the agency. We handled hundreds of bank failures, including the largest ever, Continental Illinois.

I'm a firm believer in the importance of a strong deposit insurance system administered by an independent agency, free of undue political pressures. I witnessed firsthand how a weak and politicized deposit insurance agency—the old FSLIC—was unable to deal with an obvious and growing crisis in the S&L industry. The cost was staggering.

Congress is focused currently on merging the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF). I was asked recently to testify on this issue and the adequacy of the deposit insurance funds. I took the opportunity to discuss not only those relatively minor issues, but also a range of broader and more important issues that remain unresolved despite enactment of last year's financial reform law. A condensed version of the testimony follows.

Merging the deposit insurance funds

I support combining the BIF and the SAIF. Combining the funds will create a larger, more diversified insurance pool, always a desirable goal.

The BIF stands at about $29 billion or 1.38 percent of insured deposits. The SAIF stands at roughly $10 billion or 1.44 percent of insured deposits. The combined fund would total nearly $40 billion or 1.4 percent of insured deposits.

Banks and S&Ls are engaged in essentially the same businesses today. Indeed, two of the five largest holders of SAIF-insured deposits are Bank of America and First Union. The FDIC administers both funds, and it has regulatory authority over the member institutions in each fund.

Moreover, the SAIF is in good shape today due, in part, to contributions BIF-insured institutions were required to make to restore the SAIF's financial health. It would be a mistake, in my judgment, to risk that a stand-alone, insufficiently diversified SAIF would get into difficulty again.

The adequacy of the statutory designated reserve ratio of 1.25 percent

It's important to understand that there is no deposit insurance "fund." The FDIC collects premiums (taxes) from banks and thrifts and turns them over to the Treasury. If the FDIC collects more taxes than it spends, the excess is counted toward a reduction of the federal deficit (or an increase in the surplus).

The Treasury duly records the payments made by the FDIC. The money itself, being fungible, is spent on welfare, defense, education and the like. Should the FDIC need money to handle a failure, the Treasury borrows the funds in the market. The outlay by the FDIC counts as an increase in the federal deficit.

The object in collecting premiums from banks and thrifts is not to build a "fund," but to ensure that over time the deposit insurance program pays for itself. The so-called "fund" is simply a running scorecard to determine whether banks and thrifts have paid in more than they have taken out.

It's difficult to know how to respond to whether a nonexistent fund should be maintained at an arbitrary 1.25 percent of insured deposits. The question for me is whether banks and thrifts have borne the cost of the deposit insurance system. I believe they have and should not be required to pay more, absent compelling arguments to the contrary.

We are all aware of the breakdown in public policy that led to the thrift crisis and created huge losses for the FSLIC and taxpayers. Putting aside that massive and inexcusable public policy failure, the deposit insurance system has withstood the test of time.

Banks have contributed (including interest) $29 billion more to the BIF over the past 65 years than has been expended to cover the FDIC's operating expenses and the cost of bank failures. This record is remarkable considering that from 1981 to 1992 the FDIC handled the worst bank crisis since the Great Depression.

The FDIC made it through this period without costing the taxpayers a dime. The "fund" went "negative" on paper briefly in the early 1990s only because the General Accounting Office required the FDIC to create nearly $15 billion in excess loss reserves.

For every $1 billion tied up in the nonexistent FDIC fund, banks and thrifts are unable to make $10 billion of new loans to support economic development. If the nonexistent fund is maintained at 1.5 percent of insured deposits, instead of 1.25 percent, that will reduce bank capital by some $7 billion and reduce lending by $70 billion.

I don't believe a compelling case can be made for increasing the fund beyond 1.25 percent of insured deposits. Several things have changed since the early 1990s to suggest a lower level might be more appropriate.

Recently enacted nationwide banking should reduce materially the number of failures, as banks diversify geographically and as they become takeover candidates whenever they encounter problems. About 85 percent of failed bank assets during the 1980s were lodged in just four states that suffered severe regional economic downturns.

One of the best protections for the FDIC is that deposit insurance premiums are now on a "pay-as-you-go" basis. There is no longer a maximum premium that banks and thrifts can be assessed. The FDIC is required to levy whatever premium is necessary to maintain the fund at 1.25 percent.

We now have in place a national depositor preference law. This law gives the FDIC a higher priority claim against a failed bank's assets and is expected to reduce the FDIC's losses. Congress should amend this law again to give preference to insured deposits. This would reduce substantially the FDIC's exposure to losses and would enable the FDIC to resolve the failures of even the largest banks at little or no cost.

Some people argue that the early intervention law requiring regulators to close down a bank or thrift while it still has positive capital will reduce the FDIC's losses. I fear that tying regulators' hands in this fashion will some day haunt us.

If the FDIC had been forced to observe mark-to-market accounting and early intervention rules in the 1980s, its losses in the savings bank industry would have been measured in the tens of billions of dollars instead of the minimal $1.8 billion we actually lost. Moreover, agricultural bank failures might well have been measured in the thousands instead of the hundreds, and several money center banks likely would have required intervention.

Arbitrary early intervention requirements will likely exacerbate the FDIC's losses when systemic problems arise. Regulators should be able to use judgment when a national or regional economic emergency exists. Thrift regulators misused that discretion during the 1980s (with considerable support from the administration and Congress). But it was put to very good use by bank regulators.

If we had not had and used that discretion, the economic consequences would have been severe. Stringent early intervention requirements should be abolished promptly.

Other legislative or regulatory changes regarding the deposit insurance system

The Office of Thrift Supervision (OTS) and the Comptroller of the Currency (OCC) should be merged. The heads of both agencies report to the Treasury. Both agencies employ the same procedures to supervise and regulate the institutions under their jurisdiction. Their member institutions are engaged in essentially the same businesses. Supervision would be enhanced and costs reduced by combining the resources and talents of these two agencies.

An important benefit of combining the OTS and OCC would be the elimination of one of them from the FDIC board of directors. The FDIC has a five-member board of directors—three of whom are appointed by the president and two of whom are the heads of the OTS and OCC. Whenever the FDIC board has a vacancy, which has been more often than not in recent years, the Treasury is able to undermine the FDIC's independence.

A few years ago, for example, the heads of the OTS and OCC forced the FDIC to abandon its program of participating in the examinations of larger institutions and those evidencing problems. The FDIC implemented this program in 1982 during my chairmanship, and it worked well. Due to a FDIC board resolution pushed through by the OTS and OCC, the FDIC is no longer able to participate in exams of federal S&Ls or national banks without prior authorization from the FDIC board.

The FDIC staff asked for permission to examine First National Bank of Keystone and was rebuffed. The subsequent failure of that bank cost the FDIC almost as much as the failure of Continental Illinois.

One of the clear lessons of the S&L crisis is that we need and must maintain a strong, well-financed and independent deposit insurer. Eliminating either or both of Treasury's two seats on the FDIC board is a very important reform.

I also believe that the FDIC should be removed from the federal budget. The agency was off-budget for over 30 years until someone figured out that by putting it on budget its money could be appropriated for purposes for which they were not intended. If the FDIC were restored to its off-budget status, its fund would once again become a reality, and we could have a meaningful dialogue about its appropriate size. And we could debate whether we should eliminate the FDIC's line of credit at the U.S. Treasury, a reform I also favor.

Our deposit insurance system served us well for over 60 years, but it was constructed in a different era for a much different financial system. Federal deposit insurance was conceived in a horse and buggy financial world.

The moral hazard presented by a federal guarantee on deposits was kept under reasonable control by limiting the ways in which financial institutions could get into trouble. Competition was tightly controlled through restraints on entry, restrictions on geographic expansion, controls on deposit interest rates and tight limits on permissible activities. The FDIC's risks were diffused through some 15,000 banks, few of which were large and complex.

Our financial landscape today bears little resemblance to the system of 60 years ago. The controls are largely gone. The competition is intense and the pace is fast, unrelenting and unforgiving. Thousands of institutions have already disappeared through mergers. Only eight of the 25 largest banking companies in 1980 still exist today. Global behemoths offer every conceivable financial service.

One has to wonder how our deposit insurance system will cope with serious trouble in one or more of these mega-institutions—or whether it should even try. One has to wonder why some mega-institutions are part of the federal regulatory and insurance apparatus while others are not.

What, for example, could the FDIC do if Citigroup got into serious difficulty? Citigroup, at nearly $800 billion in size, towers over the $29 billion FDIC fund. Most of Citigroup's operations are abroad, most of its activities are not traditional banking and only a handful of its liabilities are FDIC insured.

If it is determined that the FDIC should involve itself in the likes of Citigroup, how about Prudential, Merrill Lynch or AIG? These companies are very big and very important. Their failure would be at least as catastrophic as the failure of a major bank.

I believe it's time for Congress to examine the structure and function of the federal safety net and regulatory apparatus. What should be the function of deposit insurance in our modern world? What kinds of institutions should be covered by bank-type regulation and by deposit insurance? Are some too big and too complex to be included in the system? Should there be a separate system for very large and complex institutions? How can we enlist the private sector to a greater degree in reducing the moral hazard of deposit insurance?

These are but a few of the important questions that come to mind whenever I reflect on our new financial system. We have not even identified all the issues, much less developed a plan for addressing them. Forums like this one by The Region are important in helping us focus on the challenges ahead.

William M. Isaac is founder and chairman of The Secura Group, a financial institutions consulting firm, and chairman of Secura Burnett Co., L.L.C. He served for nearly eight years as a member of the board of directors of the Federal Deposit Insurance Corp. and was chairman from 1981 to 1985. Isaac also served as chairman of the Federal Financial Institutions Examination Council and is a member of the Depository Institutions Deregulation Committee and the Vice President's Task Group on Regulation of Financial Services. He also writes a regular column for the American Banker.