An FDIC closing is a stab at the heart of all community banks.
Few medium-size businesses, government units, or hospitals could operate with cash balances under the $100,000 insurance ceiling. So when the FDIC closes a bank, these depositors face serious losses.
The closing a few years ago of Oakwood Deposit Bank Co. in Ohio, for instance, threatened the tiny municipality of Oakwood, which stood to lose more than half of its $600,000 annual revenue.
What scares community bankers is the unstated "too big to fail" doctrine. The FDIC works to ensure that larger banks in trouble are merged into surviving banks, so that no depositors are harmed, no matter the size of their balances.
As for smaller banks, the FDIC either considers their failure not important enough to hurt the economy or finds no other bank willing to absorb one in trouble. So public bodies and businesses that need large operating balances are bound to look to larger banks, where their deposits seem much more secure no matter how much they exceed $100,000.
The doctrine weakens small banks and robs their communities of deposits that could otherwise be lent in them.
What can be done?
With regard to public deposits, many states and communities have laws and regulations requiring that solid assets be pledged to collateralize public deposits. In Pennsylvania, for example, at one time banks needed $3 of government or local municipal bonds behind every dollar of public deposits on hand. How much safer can you get?
But pledges have their problems.
First, segregating assets to back public deposits means less money to back private deposits in case of liquidation. That is another reason for corporate CFOs to keep funds at large banks, which offer the "too big to fail" security blanket.
Second, pledged collateral can be tampered with or subject to fraud. In Oakwood Deposit Bank's case, collateral originally worth $140,000 was found to be worth only $2,000 when presented for redemption.
Is the answer higher deposit ceilings behind public deposits? Some lawmakers propose this, even suggesting full deposit coverage for all public funds.
But again, this leaves out private deposits. And more importantly, full deposit coverage would lead bank executives to go hog-wild, because government insurance would bail their customers out. Such a policy would undoubtedly lead first to laxity and eventually to far more government oversight of our banking system.
Why not rely on municipal treasurers and corporate CFOs to scrutinize the banks where their deposits exceed the insurance limit? Well, how many of these officials have time to do a thorough evaluation before they choose a bank? And how many have the skill? Banking is a complex business, rife with opportunities for hidden fraud; even professional security analysts are fooled time after time.
In the end these cases come down to one question: Where were the regulators?
Oakwood's CEO perpetrated a $40 million fraud in a $72 million-asset bank. Regulators shuttered First National Bank of Keystone in West Virginia only after finding that half of its $1.1 billion of assets were missing!
More vigorous regulation would benefit not just the public but the rest of the community banking industry. And maybe the industry would agree.
According to a Kansas City Fed survey, community banks worry about regulation less than they used to. In 1994 they said compliance was the most significant problem they expected to encounter. In 2001 it was not even in the top five.
Some water has gone over the dam since then, but I suspect bankers would support devoting more resources to identifying rogue banks before they do more damage to the industry.
Mr. Nadler, an American Banker contributing editor, is a professor emeritus of finance at Rutgers University Graduate School of Management in Newark, N.J.
