With its new depositor preference proposal, the Federal Deposit Insurance Corp. decided to skip over the current problem and fix one that doesn't exist yet.
On Feb. 12 the FDIC proposed a relatively simple idea: when a bank fails, foreign deposits that are payable in the U.S. are on an equal footing with domestic deposits, but are not insured by the U.S. government.
In other words, these foreign deposits are preferred but not insured.
While simple, it's a bit of a head-scratcher why the FDIC bothered to say this at all. Such "dual-pay" accounts where the depositor can claim their funds in their home country or in the U.S. are uncommon at best. What's more, it's not as though tons of foreigners have been filing claims for FDIC insurance.
But the agency is reacting to two things.
The immediate prompt is a move by U.K. regulators who want their depositors to get repaid on an equal footing with U.S. depositors in the event a bank fails.
The other motivator is less obvious, but more important.
The FDIC believes that it's only a matter of time before large U.S. banks start offering these "dual-pay" accounts to their customers abroad. Once foreign customers are able to demand repayment of deposits in the U.S., it's not a big leap to think some of them will demand insurance coverage.
"Banks could begin to offer these accounts," says Art Murton, the FDIC's director of insurance and research. "You can assign whatever probability you want to that, but the potential outcome to be the deposit insurer to the world we don't want to look back and say, 'We had an opportunity where we could have prevented that from happening.' "
And Murton doesn't think the problem will stop with individual institutions. Some entrepreneur, he says, will figure out a way to leverage the opportunity.
"Once the door is open, then other people could think of how to exploit that," he says.
If you want an example of what Murton is worried about, look no further than Promontory's hugely successful CDARS program, which allows banks to offer nearly unlimited insurance to their customers.
The FDIC's concerns are directly traceable to the Dodd-Frank Act of 2010, which changed the base on which insurance premiums are assessed. Before 2010, banks had a huge disincentive to offer any sort of dual-pay account because their premium costs would have spiked. Today, with the FDIC assessment based on assets, banks may come to view dual-pay accounts as an inexpensive way to attract more foreign deposits.
But before we look too far down the road, let's review some of the context surrounding this issue.
Depositor preference which determines who gets repaid first in a failure dates to the 1993 budget law.
Congress came up with it as a gimmick to claim the FDIC would save money when banks failed. Under the law, the FDIC's resolution costs and uninsured depositors are repaid before other creditors.
In a 1994 opinion by the agency's acting general counsel, the FDIC made it clear that this preference only applies to domestic deposits.
OK, now let's also go back to that original factor motivating the FDIC's proposal demands by U.K. regulators that British depositors in U.S. banks get the same payout as U.S. depositors.
Last fall, the U.K.'s Financial Services Authority told U.S. banks that they could only continue to take U.K. deposits if they did one of three things: set up a separate subsidiary for their U.K. operations; establish a trust with U.K. depositors as the beneficiaries; or offer dual-pay accounts.
By far, U.S. banks prefer the dual-pay choice. Knowing that, the FDIC is using this proposal to get ahead of the day when these "dual-pay" account holders claim that their deposits are insured.
OK, so that's the history and the FDIC's position. What about the banks?
The large banks with foreign operations deny they have any interest in offering these dual-pay accounts. And no one the U.K., the banks or the foreign depositors is demanding FDIC insurance.
The industry thinks the FDIC could solve this issue by simply changing its '94 legal opinion to say that foreign deposits get the same preference as domestic deposits when a bank fails.
"FDIC is doing some good things, but it's not enough," says Cecelia Calaby, executive director of the ABA Securities Association. "What they've not done is directly taken away the depositor preference issue, which would resolve the FSA's concerns and would make it possible for banks not to have to implement dual-pay, which the banks really don't want to do."
Calaby says setting up dual-pay accounts involves operational and technological hassles and could create uncertainty in a resolution or in the event a government decided to seize private-sector assets.
"Once you make the deposit dual-pay, it opens up a raft of potential problems from a resolution perspective and from a liquidity perspective," Calaby says. "How can a bank know in the U.S. which non-U.S. depositors are going to make claims on what basis and at what time?"
But the FDIC is not convinced that a strong legal argument exists for rewriting the 1994 opinion.
More important, Murton says, the industry's fix doesn't address the agency's problem, because "it leaves the door open for banks to make deposits in foreign branches insured by the FDIC."
Basically Murton sees the industry's request to rewrite the 1994 opinion as a way to fix the banks' problem without addressing the government's concerns. Given a choice between the two, the FDIC prefers its proposal.
The plan is out for public comment, and Murton says the agency is open to changes.
"If there are better ways to accomplish our goals with less burden, we are receptive to that," he says.
So here's the bottom line.
The FDIC thinks dual-pay accounts are inevitable and it wants everyone to know those funds will not be insured.
The industry says it has no interest in dual-pay accounts. It simply wants the FDIC to rewrite its rules to give foreign deposits the same payback preference as domestic deposits without insurance.
It's pretty clear the FDIC doesn't believe the banks.