The FDIC Should Buy Reinsurance for Deposits

The current form of deposit insurance in the United States has contributed in a very large way to the emergence of the banking and thrift crises of the late 1980s.

Deposit insurance drives insured institutions to gamble, because they profit from a win but do not lose when a gamble goes very bad.

In the absence of deposit insurance, any institution taking on large risks would scare away its depositors. Their departure would discipline the institution.

Risk-Based Pricing

Without such discipline, there are only two ways to prevent irresponsible risk taking by insured financial institutions.

* To try to regulate away such irresponsibility by raising regulatory obstacles to risky investment and speculation. This has been the U.S. approach. Its failures are now apparent to all.

* To reform deposit insurance to reintroduce incentives against excessive risk taking. The most obvious way to do this is by pricing deposit insurance differentially, charging higher rates to more risky institutions.

The risk-based pricing of deposit insurance makes as much sense as the risk-based pricing of any other kind of insurance.

In particular it would restore some discipline by penalizing financial institutions that invest irresponsibly. Much as risk-based fire insurance induces people to install sprinklers or risk-based theft insurance may motivate installation of anti-burglary systems, risk-based pricing of deposit insurance can motivate prudent banking behavior.

The Bureaucratic Obstacle

Now if the cure is so simple, why has it not been introduced?

The main obstacle is that operating and implementing a risk-based pricing system is difficult, probably beyond the capabilities of the regulatory bureaucracies.

Assessing the riskiness of banks and thrifts is no simple task. Indeed, if constructed poorly, a risk-based deposit insurance premium program could do more harm than good, causing resource misallocation and distorting financial markets.

The key to a workable risk-based system is to let the market - not the bureaucrats - price risk.

A New Key to Market Discipline

This can be done by converting the operations of the Federal Deposit Insurance Corp. into underwriting and then buying reinsurance.

In many ways, this would be analogous to the securitization operations of federal agencies such as the Federal National Mortgage Associationthe Government National Mortgage Association, the Federal Home Loan Mortgage Corp., and so on.

Under federal agency securitization, the agency purchases a debt security such as a mortgage, farm, or export loan and then sells it (usually after pooling) to private-sector investors, generally "with recourse." The federal agencies first provide loan funds and then purchase other loan funds to cover their positions, retaining a markup or price differential.

Multiple Benefits

Similarly, under deposit insurance reinsurance, the FDIC would first provide deposit insurance and then purchase deposit reinsurance policy by policy or by groups of policies.

The results of this "securitizing" of insurance would be market pricing and efficiency plus reduced risk exposure for the government and the taxpayer.

The FDIC has never really given serious consideration to buying reinsurance, although it considered a proposal to reinsure 10% of its exposure, apparently rejecting it in favor of the idea of capital basing insurance premiums. That was a mistake.

The Private-Sector Model

The purchase of reinsurance for deposit insurance policies issued by the FDIC would operate much like reinsurance for private-sector insurance underwriters, where the risks of a policy are transferred to the reinsurer.

In addition the underwriter would bear some residual risk toward the insuree for indemnities that the reinsurer failed to pay, such as in the case of reinsurer default or bankruptcy.

In the capacity of the underwriter for deposit insurance that is subsequently reinsured, the FDIC would in effect relinquish to reinsurers the responsibility for pricing individual policies.

This would resolve the dilemma of how to assess and price individual risk-based deposit insurance. The market would do it.

The FDIC would continue to act as the ultimate guarantor of safety but would have no need to play a role as examiner or monitor. The responsibility for monitoring the behavior of insured institutions would be transferred to the private sector - to the reinsurers and the rating agencies.

Most important, the exposure of the FDIC would be a minuscule residual compared to what prevails under the current system.

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