Depositors May Accept 90% Coverage

Suppose the Federal Deposit Insurance Corp. asked depositors to share the risk of bank failures. More specifically, suppose the FDIC offered to insure only 90% of bank deposits, leaving 10% of everyone's balances exposed. Would depositors agree? Would Congress dare ask them?

Both just might, if the behavior of depositors and voters in the current Rhode Island banking crisis is any indication.

The Rhode Island banking crisis began on Dec. 31, 1990, when a private deposit insurer failed, forcing 45 banks and credit unions, with $1.7 billion in deposits, to close. Since then, 32 institutions, with $500 million in deposits, have either reopened with federal insurance or refunded deposits. The rest remain closed. Those unable to reopen will be liquidated, at an estimated loss of $150 million.

Depositors Take a Hit

The governor proposed, and the legislature agreed, that taxpayers would cover most of the loss but that depositors would pay for some of it. Depositors would pay by accepting a delay in the return of principal, forgoing interest payments, and losing part of balances above $100,000.

Naturally, some depositors objected. They wanted the state to reimburse them fully and immediately. They called talk shows, organized rallies, marched on the Statehouse, and filed lawsuits.

But they were the minority. Most depositors were restrained, patient, and understanding. Most recognize that the state has a budget deficit that makes a complete bailout difficult, both politically and economically. Many take comfort in their deposits at other banks. Some even admit that they made a risk-return tradeoff and lost.

Still others have shown a sophisticated understanding of the time value of money. They have proposed deposit-for-equity swaps to recapitalize and reopen the closed institutions. Under these proposals, depositors would give up some of their balances (often 10%) to have the rest earn interest and be available immediately.

The Voters Understand

Like depositors, voters have shown understanding. Opinion polls show that the majority support the solution, even though it means higher taxes.

The amazing calm with which depositors and voters have greeted the banking crisis in Rhode Island has national implications. It suggests that Congress might underestimate the willingness of all depositors to share in the cost of bank failures.

Indeed, current proposals for deposit insurance reform ask only for a limit on coverage of large or brokered deposits. These proposals also ask banks to bear the cost through higher assessments or higher capital requirements.

Based on Rhode Island's experience, a better proposal might be to insure 90% of bank deposits, regardless of the amount or the source.

Some Drawbacks

Such a proposal has obvious drawbacks. Depositors would lose money if their bank failed; elected officials might lose some votes; the FDIC would have to watch for runs; and some disintermediation (a shift to direct purchase of Treasury securities) might occur.

But the benefits would be substantial. With fewer deposits covered, the cost of bank failures to the FDIC and to the taxpayers would be less. A lower cost of bank failures would mean lower deposit insurance premiums and higher earnings for banks, a welcome development in an industry starved for profits.

Another benefit would be the equal treatment of all depositors, large and small. For some reason, legislators insist on believing that large depositors are fat cats. They are not. The fat cats keep their money with brokers, trust departments, or money managers in instruments other than deposits.

Large depositors are ordinary people who simply like to save. Between the ages of 45 and 65, with both spouses working, the mortgage paid, and the kids gone, people who like to save can save a lot. With pension rollovers and house-sale proceeds, they can accumulate $300,000 or more. These people certainly deserve the same insurance protection as other depositors.

Valuable Customers

They should not be driven from well-run banks because of a cap on deposit insurance. Large depositors are especially important to small community banks where deposits are scarce and customers precious. The 90% coverage would allow the well-run community bank to retain the large depositor.

However, 90% coverage would make depositors more discerning and vigilant. The Rhode Island experience shows that when depositors are faced with a loss of risk-free coverage, they learn fast. The banking system would ultimately benefit because, with their withdrawals, depositors could impose discipline on a bank faster than the FDIC.

The flip side of market discipline is market reward, and 90% coverage would reward the conservatively run bank. The reward would be evident in platform conversations. Right now, customer service representatives have no ammunition when their customers come in to withdraw money for redeposit into a higher-paying but riskier bank. They can cite their bank's higher capital ratio, more conservative loan portfolio, and more consistent earnings. But their arguments fall on deaf ears. The customers know that the other bank has 100% FDIC insurance, so they don't care.

A Way to Get Cheap Funds

With 90% coverage, customers would care. Knowing the possibility of loss, depositors would be concerned about the strength of a bank. The customer service representative's arguments would become persuasive. The conservative bank would be rewarded with more deposits, at lower cost.

Indeed, rewarding the conservatively run bank should be the thrust of banking reform. That thrust is seen in risk-based capital requirements and proposals to eliminate interstate banking laws. The former reward conservative balance sheets with lower capital requirements and the later encourage mergers and wring excess capacity out of the system. A deposit insurance system of 90% coverage would continue that trend.

Finally, 90% coverage would not cut off brokered deposits, as some proposals do. Despite their bad reputation, brokered deposits perform at least two useful economic functions. By tapping distant markets, they allow banks to boost deposits without cannibalizing (raising the rates on) existing balances. Also, they give depositors in low-rate markets the chance to enjoy higher rates.

The advantages are obvious: lower cost of bank failures, equal treatment of all depositors, keeping large depositors in the small community bank, conscientious depositors, conservative banks, and a role for brokered deposits. A deposit insurance system of 90% coverage offers some solid benefits. Based on Rhode Island's experience, it just might work.

Mr. McConaghy is president of McConaghy & Co., a management consulting frim in Pawtucket, R.I.

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