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TBTF Is a Symptom of a Bigger Problem

The recent debate over "too big to fail" misses the point that it is a symptom of a much bigger unsolved problem, namely the need for real deposit insurance reform.

Besides dealing with TBTF banks, such reform would also address the risks to the Federal Deposit Insurance Corp. and ultimately the taxpayer of the nearly 400 failed banks during the financial crisis, especially de novos, rapidly growing banks and those with concentrations of subprime or other high-risk assets.

With all due respect to the FDIC, it has a dismal record as an insurance corporation, with its fund effectively gone insolvent not once but twice (in 1991-92 and more recently during 2009-11). Banks can't go insolvent twice, so why should their insurer?

The FDIC apparently has forgotten about the "corporation" in its name and acts more like a government agency that's been captured by the industry it regulates. That is, the FDIC primarily responds to the interests of the banking industry from which it derives its premiums rather than the depositors and taxpayers who ultimately back the FDIC through its line of credit with Treasury and the government's full faith and credit.

What would real deposit insurance reform look like?

Real deposit insurance reform focuses on insuring depositors (not banks) and ultimately taxpayers backing the system against loss resulting from bank failures. This is consistent with the purpose of the FDIC as stated in its first 1934 annual report.

The bank depositors' view of deposit insurance reform puts the "Corporation" back in the FDIC so it acts more like a real insurance company rather than a government agency:

  1. The statutory minimum Designated Reserve Ratio should be increased to at least 1.5%, so that figure becomes the floor rather than the ceiling. The Dodd-Frank Act raised the minimum to 1.35% from 1.15% and allowed the FDIC to rebate amounts above 1.5%.
  2. There should be NO cap on the size of the DRR or the insurance fund. It is true that Dodd-Frank removed the statutory cap, but 1.5% could become the ceiling in practice, since the law still allows the FDIC to pay rebates above that level.
  3. NO rebates should be paid to banks even in the best of times. Granted, the FDIC issued a rule in 2011 indefinitely suspending such "dividends," saying it would instead lower assessment levels if the ratio climbs above 2% and lower them again should the figure exceed 2.5%. (The recently announced $6 billion refund is for an extraordinary prepayment of premiums during the crisis.) But, like any insurance corporation or bank the FDIC must build up reserves during good times since there will be future crises that may again threaten the fund's solvency. Banks, conflicted by moral hazard, will always fight for maximum FDIC coverage at the least possible cost, since the FDIC is ultimately backed by Other People's Money.
  4. The deposit insurance limit should never have been raised above $100,000. It should be lowered to that level from the current $250,000. We must continue to reduce the federal safety net in the same way we eliminated unlimited temporary transaction account coverage. This encourages market discipline by depositors who will more carefully monitor bank risk. The FDIC was established to protect "small savers," and $100,000 coverage per account, with the option of having multiple accounts, does that. The Federal Reserve Board's most recent 2010 Survey of Consumer Finances shows the median transaction and CD balances for all families holding assets at $3,500 and $20,000, respectively, with the comparable levels for those in the wealthiest 10% by net worth at $60,800 and $65,000.
  5. In addition to regular premiums, special risk deposit premiums should be annually assessed in a 3- to 10-basis-point range for banks with a targeted risk profile such as those with subprime lending or rapid growth as well as de novo financial institutions. Using the minimum 3-basis-point assessment, a rapidly growing de novo bank making subprime loans would have at least a 9-basis-point annual special assessment.
  6. A 3- to 8-basis-point special assessment for TBTF banks based on total assets rather than deposits. A rapidly growing TBTF bank with a relatively small insured deposit base but a subprime lending affiliate would pay the highest 8-basis-point annual premium plus the 6-basis-point special risk assessments for rapid growth and subprime lending.

My TBTF special assessment proposal follows from the four TBTF "facts of life":

  1. TBTF has existed since 1984, when the government intervened in the collapse of Continental Illinois.
  2. TBTF cannot be eliminated
  3. TBTF is an extremely valuable competitive advantage and benefit to the banks in this exclusive club
  4. TBTF banks pay nothing for this privilege

Realizing that nothing can be done about the first three facts, good public policy dictates a TBTF assessment. Unlike increased capital requirements, which banks can delay, dilute or dodge, a meaningful TBTF assessment immediately affects quarterly profits, which is what big bank CEOs and their shareholders really care about.

Why didn't the FDIC adapt real deposit insurance reform?

The above deposit insurance reforms likely would have prevented the insurance fund from going into the red a second time. But, they were never seriously considered because the FDIC and its congressional overseers answered primarily to banks rather than depositors.

I proposed all the above reforms and laid out the TBTF "facts of life" in 1995 and again in 2000 (when the insurance limit was still $100,000) in testimony before the FDIC and Congress. These proposals were called "outrageous" by a former FDIC Chairman and the largest banking trade association in 1995.

Yet rather than increasing the statutory DRR minimum to 1.50%, the 2005 FDIC Reform Act reduced it to 1.15%. Most banks paid no premiums for years, and many received rebates and credits. Needless to say there were no special assessments for subprime lending, new, rapidly growing, or TBTF banks.

Can you think of another insurance corporation faced with unknown and potentially huge risks that does not charge premiums, gives rebates, and fails to build up its reserves during good times? The recent crisis has caused the FDIC and Congress to rethink some of these positions, but it has been too little, too late.

After two decades of research I have concluded that real deposit insurance reform (including a TBTF fix) is not possible as long as the FDIC and Congress primarily respond to the interests of the banking industry rather than the banking public.

Kenneth H. Thomas, an independent bank consultant and economist, was a lecturer in finance at the University of Pennsylvania's Wharton School for more than 40 years.


(2) Comments



Comments (2)
The minuscule capital requirements for banks whenever something was officially or privately perceived as "absolutely safe" are the most important growth-hormones which help turn some banks into too big to fail bank. Stop giving the banks these and much of the problem will solve itself in a natural way.
Posted by Per Kurowski | Tuesday, May 14 2013 at 1:09PM ET
Hooray for Ken Thomas for shining the light on such an important topic again.

In 2006 when the FDIC first embarked upon risk-based insurance pricing, I was highly critical of the draft of the new assessment program to be adopted. I wrote a detailed critique for senior FDIC management which I presented to them in 2006. I was ridiculed for my criticism and suggestions - shown by my following key bullet points. I was first in the agency in 2004 to suggest charging large banks for their incremental "complexity" risk which required more regulatory oversight costs but could not get others to agree.

Had my suggestions and critique been acknowledged, the FDIC insurance fund never would have gone bankrupt. My proposals would have maintained ample reserves and saved many billions in needless insurance outlays. Every one of my suggestions from my formal, 2006 critique were scheduled for planned implementation five (5) years later in 2011 - several years after the banking crisis!

Here is a recap of the salient points of my 2006 critique.

1. CAMELS Component rating "weights" are too subjective and not fully supportable
2. "Institutionalizing" Analyst debt/bond ratings is a concern
3. Insurance Risk Assessment should focus on insured and on affiliates & holding company as well
4. Consider "Complexity" and Size as a determinant for insurance risk assessment
5. The FDIC's (LIDI) Large Bank Risk Rating needs to be made more granular. A, B, C, grades are not meaningful.

Also, I pointed out to senior agency officials why and how the FDIC should revise insurance assessments to address the following:

Loss mitigation efforts and cloudy accounting/reporting regarding Subprime loan modifications, as well ADC and Commercial Real Estate lending.

Technical Loan Defaults -- how do these get tracked and rolled up into any reports/exams.
Policy question: should Examiners focus on such and be encouraged to report as "Special Mention" or "Classify" as warranted?

Surprisingly, the FDIC insurance assessments presently do not utilize the FDIC's own internal offsite models which can serve as an early barometer of increasing risk exposure. The FDIC does not trust its own models.

CDO and Structured Security products accounting result in faulty loss exposure estimates. Presently, loan loss reserve ratios and security mark-downs booked by banks are all over the board for the same class of loans and securities. This is one reason that investors do not have any confidence in audited financial statements of banks.

It has been a real shame for not only the banking community but public how the FDIC mismanaged the deposit pricing system. The woman who headed up the unit reported to senior officials that she took various actions that she "never performed" such as stress-testing to see how the fund would hold up. This individual left the FDIC almost two years ago and now is heading up stress-testing at the Federal Reserve.

I used to head up the FDIC's LIDI (large bank) program until my repeated whistleblower disclosures.

See my blog at

Dwight Haskins
Posted by Dwihas3 | Friday, May 10 2013 at 10:35AM ET
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