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End the TAG Program – It Puts Banks and the Economy at Risk

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Banks are lobbying Congress to extend the TAG program, yet another of the Dodd-Frank policies (this one carried over from a temporary crisis measure) that will have adverse effects on the health of banks and of the U.S. economy. The troubles that this one will cause, however, were so obvious from the beginning that they could hardly be called unintended consequences when they occur.

Scheduled to expire at the end of 2012, TAG places an FDIC guarantee on bank transaction accounts of any size—exceeding the current insured deposit ceiling of $250,000—as long as the deposit earns no interest. About $1.6 trillion, or 13% of all bank deposits, are now held under this program.

It is a measure of the shocking condition of the economy that many corporations have been using this device to store their excess cash, apparently willing to suffer a loss of about 2% a year (the current inflation rate) to get a government guarantee and immediate access to their funds.

What could possibly be wrong with a program that provides banks with $1.6 trillion in deposits on which they have to pay no interest? That’s probably the question that was presented to Congress when it initially considered this idea, and appears to be the way many bankers are thinking about it now.

The answer is that this money is the hottest of the hot. Since TAG accounts earn no interest and are withdrawable on demand, these funds will all disappear if the economy ever begins to recover and interest rates start to rise. At the same time, and for the same reasons, the Treasury or GSE securities in which the funds have likely been invested will fall in value, bringing an abrupt decline in bank liquidity and regulatory capital as the assets purchased with the TAG funds are marked to market.

The consequences for the economy will also be adverse, a point that Congress should keep in mind as it considers an extension of the program. When bank liquidity and capital decline, banks stop lending. If interest rates began to rise because the economy was recovering, the recovery would be cut short, or at least curtailed. But if interest rates began to rise because of a fear of inflation—a distinct possibility if the entitlement costs are not controlled—then we have the worst of both worlds. Funds would be withdrawn from the banks so that they can be invested in inflation hedges—land, precious metals and commodities—slowing economic growth and fueling inflation at the same time, a return of 1970s-style stagflation.

Finally, for all the concern in Congress and elsewhere about banks that are too big to fail, the TAG program makes the problem worse. When FDIC insurance covers another substantial portion of bank deposits, it will further reduce market discipline, ensuring that there will be even less private sector control of bank risk-taking.

As usual, bad government policies that distort markets are difficult to end. Some banks are happy to profit temporarily from the spread between Treasury or GSE securities and the zero interest rate they pay for TAG deposits. Some may even need the support to avoid failure.

But we all know that this is not the way the system should work. Banks should pay a competitive rate for their deposits, and depositors should provide funds to banks to gain a return, because that is a financially sound use of their money.

Congress should realize that with the TAG program they are riding a tiger. There is no safe or easy way to get off. Nor will there ever be. The one good thing about this program is that it was scheduled to end on Dec. 31, 2012. Congress should let it happen.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute 

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Comments (3)
Peter Wallison is correct about NOW is simply NOT the fiscal, financial, or economic time to allow FDIC TAG to abruptly expire and let $1.6 trillion in chips fall where they may. This would put banks and the economy at risk as Dr. Wallison points out and would immediately tranforming risk-free deposits into risk-assets. Not eaxctly what the Nation needs right now given all the tremendous fiscal uncertainty and fragile economic growth. Congress must act on a temporary TAG extension to avoid this financial sector cliff. Franlly, when the Federal Reserve ends its aggressive monetary policy forcing today's negative real interest rates, and the nation's CFO's and State Treasurers again are interested in a rate of return on their cash deposits -- then TAG will fix itself. But today's financial environemnt demands a TAG extension.
Posted by TruthPanther | Monday, December 03 2012 at 1:08PM ET
"Triumph or Tragedy" we need to re-read what's in it not arbitrarily pass it, I do agree measures need to be reconsidered and possibly extended but only after an audit on an Independent Basis to determine the health of which institutions stand to gain the most.

With Q-E3 an almost certainty and today's manufacturing report some measures may be needed,I think this need's a lot of thought,also keep in mind that we are still struggling to grow leg's a midst one of the biggest haircut's in modern history look, listen and proceed with caution.
Posted by FXS92663 | Monday, December 03 2012 at 5:13PM ET
ICBA and Community Banks should be fighting to end TAG. After all, just 3.4% of TAG deposits are held by Community Banks, with an average of only 17 accounts per Bank. (source: FDIC, http://www2.fdic.gov/qbp/2012sep/qbp.pdf). Something just does not compute...
Posted by Serge Milman | Optirate | Thursday, December 06 2012 at 4:32PM ET
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