I. Introduction
I. Deposit Insurance
This paper is a review and suggestions list for the U.S. deposit insurance by the Federal Deposit Insurance Corporation (FDIC). The purpose of this review is to best ensure that the deposit insurance is best able to meet its expectations and responsibilities over the coming decades. Due to several factors such as the rapid spread of globalization, advancements in technology, and consolidation in the banking industry, the services and products offered to American depositors are evolving and so must the deposit insurance that protects those individuals.
Established in 1934, and brought about by the bank panics of the Great Depression, the United States has the oldest federally supported deposit insurance in the world. The system has been very successful in performing its role as a stability factor in the banking industry. After the Great Depression, deposit insurance was able to renew the confidence in the American public, and continued to do so for the next three decades. In the 1970s and following into the 1980s, there was a banking crisis in the U.S. when hundreds of banks and thrifts were forced out of business, due to failure. Once again the deposit insurance was there as a reassurance to the public and it was successful in keeping a certain level of order in the industry.
The value of deposit insurance perhaps has no better example, than when comparing the banking crisis in the U.S. to similar situations that have occurred recently in South America and parts of Asia. While the U.S. had the deposit insurance, and was very successful in preventing bank runs, all bank failures where addressed in an orderly manner through an established system. Several of the countries in South America and Asia did not have such provisions in place when bank panic struck. Needless to say, not having deposit insurance turned out to be disastrous and many of those countries will take decades to recover fully. Due to the success of deposit insurance in the United States, many countries have now adopted insurance, in various forms across the world.
Given the benefit that deposit insurance has proved to be, the 1980s have provided valuable insight to the potentially dangerous ramifications of having a flawed insurance. The cost to the tax-payer just to fix the problem of the savings & loan crisis was totaled to be $130 billion. This presents the obvious fact that if a deposit insurance is to be successfully ran and operated, the costs of having it need to be examined closely.
In its current state, the banking system is in very good standing, however if it is to remain as such the deposit insurance must evolve to keep pace with changes in the banking system, and the economy as a whole. As it stands the insurance funds have more than $40 billion in combined reserves, bank capital levels are higher than they’ve been in several decades, and profitability in the industry has been growing. If there has ever been a time to alter the deposit insurance it should be now while the system as a whole is healthy. This will help to best position ourselves should trouble arise in the future.
This paper will now discuss the problems that have become apparent with deposit insurance, and possible measures that can be taken to resolve these issues.
Part II: The Benefits and Costs of Deposit Insurance
I. Benefits of Deposit Insurance
As discussed in the introduction, the benefits to having a deposit insurance in the United States are numerous. Several times since its creation the deposit insurance has been instrumental in ensuring the economic and financial stability of countless individuals, not to mention the country as a whole.
As it stands today the deposit insurance in the United States, as offered by the Federal Deposit Insurance Corporation is set up in its most basic form as such:
“The FDIC protects you against the loss of your insured deposits in the unlikely event that an FDIC-insured institution fails. If you or your family's deposit accounts at one FDIC-insured institution total $100,000 or less, your funds are fully insured. If you or your family has more than $100,000 at one insured institution, you can still be fully insured if your accounts meet certain requirements. You can use EDIE to determine your insurance coverage beyond the basic $100,000 amount.”
Source: (www.federalreserve.gov)
The deposit insurance is most beneficial in that it provides individuals as well as small business’ with the peace of mind that in the event of a bank failure, they will still have their money guaranteed to them. This fact alone, has perhaps been the most important determinant in the success of deposit insurance.
II. Costs of Deposit Insurance
Although the benefits of deposit insurance are certainly significant, by no means do they come with a cost. The process of insuring individuals, and thus, ending bank runs has created the problem of making depositors indifferent the actions and risk taken on by the banks. The result has been a weakening of the market discipline that insured depositors would otherwise have imposed on institutions. Without this market discipline, banks will feel more inclined to take upon risk that they would have otherwise avoided if the depositors had not been insured. This incentive to take on more risk than would be permitted if deposit insurance did not exist, is what is known as moral hazard.
There are thus two factors that must be considered when deciding what provisions to make for deposit insurance. On one hand, deposit insurance has clearly limited the level of bank runs in times of crisis, which has led to the stabilization of the United States financial system. However, on the other, deposit insurance is guilty of greatly raising the amount of risk that banks and other financial institutions would have otherwise been willing to make.
Indeed, one of the most prevalent problems that the FDIC faces with issuing deposit insurance to the banks is moral hazard. An example of this in the banking industry would be a bank taking on loans with a very large rate of default simply because they knew there is a higher profit margin possibility if the loans are payed back. While this would lead to increased profits, if all of these loans were to never default, in all likelihood the bank will soon find itself in financial crisis and it’s depositors being saved by deposit insurance. However, on the opposite side of the coin, if the high risk that the bank takes on works out in the banks favor, then their profit margins will be very high.
As if to add fuel to the fire of moral hazard in the banking industry there have been two very important revelations in the financial world starting in the late 70's and stemming into the early 80's. First, during this time period new financial institutions started to appear in the market which began to compete with the banks for the business that had previously been dominated completely by the banking industry. These new institutions known as S&L’s (savings and loans) began to acquire funds in much the same way that the banks were accustomed to doing, which in turn led to more competition in an already competitive market. These S&L’s in addition to competing with the banks were also not as heavily regulated as the banks were, which gave them an advantage in acquiring the funds necessary to run a successful financial organization. In order to help the banks compete the government created a problem that many economists foresaw at the time, however their warnings were not headed. The government actually deregulated the banks allowing them to take on more risk than they had previously been provisioned. The combination of increased competition and less regulation in any financial market is bound to spell disaster.
As it stands, with the safety net provided by the federal government, along with the market conditions that already beg the banks to take on a high level of risk, moral hazard is going to remain at high levels until something is done. The banks essentially lack any incentive to take less risk, due to the fact that they know tax payers will pick up the tab even if they get their institutions into bankruptcy. The banks are more or less making the following bet: “Heads I win, tails the taxpayer loses.”
The moral hazard created by the government safety net and the desire by the federal government to maintain the stability of the U.S. economy, has put the FDIC in a new situation that presents new issues.
Due to the fact that larger banks obviously have more money at stake, the regulators naturally have a tendency to keep these banks afloat even if they find themselves in financial difficulty. This is in part to the fact that if a large bank fails there is a much higher tendency to create a financial panic in the United States, than if some smaller bank were to fail and effect many fewer individuals. An example of this can be seen when Continental Illinois one of the ten largest banks in the US went insolvent in 1984. The FDIC not only guaranteed the money to the depositors who had less than $100,000, but also refunded those who had more than this amount. The FDIC even went so far as to prevent the losses of the bondholders in the bank. It was also later said by the Comptroller of the Currency that “similar treatment would be given to the eleven largest banks in the US.”
The primary problem thus created by the governments policy of “too big to fail” is the large banks engaging in higher amounts of moral hazard. Even worse is large depositors in these banks have no fear of losing their money in a situation of insolvency. This leads to a problem where the largest depositors are not monitoring the risk of the bank, which leads the bank managers to engage in whatever type of business practices that they please.
Part III: Proposals for Improving the Deposit Insurance
I. Merging the BIF and SAIF
In the past there was a clear distinction between thrift and banking institutions. For this reason, the FDIC set up two separate funds in order to aide the banks or the thrifts independently in times of financial crisis. The Bank Insurance Fund (BIF) was established in order to fund bank closings, while the Savings Association Insurance Fund (SAIF) was created to do the same for thrifts.
In modern times, due to mainly to financial innovations many banks and thrifts in the financial industry have begun to merge. Because the charters and operation of banks and thrifts having become increasingly similar it no longer is logical to have two separate funds, when combined they would form a more powerful and efficient fund. Separate funds are a clear example of the representation of the past, however, not the present nor the future of where banking is heading. Merging the funds would work to diversify their risks, reduce administrative expense, and most importantly increase the fund base of a banking system that is becoming more consolidated as time progresses.
Due to the fact that the banks and thrift institutions are currently receiving the same level of insurance coverage, as such, premiums should also be set equal. As it is currently established, when an institution falls under the reserve ratio requirement of 1.25% of insured deposits they are forced to pay a higher premium than an institution with an equal amount of risk that is above that point. Essentially forcing institutions to pay a higher premium when times are bad, are allowing them to pay less when all is good. This should be modified so that there is not a monetary penalty for falling under the requirement of 1.25%. The penalty should be a fixed time table that the institution needs to be above the 1.25% level, and close monitoring to ensure it does as such.
All logic points to creating a fund that is unified. This will prove to a stronger system than two separate funds that are there to support to institutions that in contemporary times, have essentially become equals. In doing this, the FDIC can also ensure that institutions with the same level of risk are charged the same premium.
In all likelihood, there would be no true downside in merging the BIF and SAIF do to the fact that separated they are weaker than they are united. Also, in part due to the fact that in contemporary times banks and S&L’s are becoming more similar, a single fund will be able to entirely service both types of institutions if a problem should arise.
II. Reducing Restrictions on Premiums
The current law mandates to the FDIC that it impose a higher premium to banks with more risk and a capital level that is under 1.25% of insured deposits. However, prevents the FDIC from issuing a premium to institutions that have high ratings and a large percentage of capitalization. While in theory this would be an incentive for banks to maintain a high level of capital, it actually puts banks with under 1.25% capital ratio at even more risk than they are already at. The law should be changed that allows, and even forces, the FDIC to impose a premium on all institutions whether or not they are well-capitalized with a good rating.
While it would at first appear that the system as it is, has been developed to limit the effects of moral hazard, the two indicators that the FDIC is using to issue risk based premiums, are themselves not necessarily tied to actual level of risk being taken by the institutions. Strong levels of capitalization and bank rating in the past have not shown to have a large correlation to the number of bank failures. While it is not proposed that banks should be permitted to have a lower percentage of bank capitalization, this factor should not necessarily determine the level of premium the banks issue. It would make more sense for the FDIC to find factors that have had a higher correlation to bank failure and use these to determine the risk based premium that will be issued. By using a more intuitive system, even though it would be difficult at first to implement, in the long run moral hazard would go down, by causing the institutions to avoid risk in order to keep premiums low.