On July 26 Congress began hearings on a number of changes in the structure of federal deposit insurance proposed by the FDIC.

While some of these changes may be desirable, reopening the deposit insurance system to statutory change may endanger the most important and least known reform enacted since the system’s adoption in 1933 — the great reduction, if not the effective elimination, of the government’s potential liability for losses from bank failures.

This liability proved very costly to the U.S. taxpayer in the 1980s.

Before the enactment of the FDIC Improvement Act in 1991, the government was effectively on the hook to fund losses to the FDIC beyond the agency’s existing resources. When losses from protecting insured (and, in most failures, uninsured) depositors exhausted the FDIC’s (and the former Federal Savings and Loan Insurance Corp.’s) reserves, there was no provision for mandatory increases in premiums to replenish the agency’s resources. Instead, the taxpayer made up much of the difference.

The S&L failures of the 1980s cost the taxpayers $150 billion, and the concurrent high cost of commercial bank failures came close to also requiring taxpayer support for the FDIC before the economy and the banks turned around.

The 1991 law requires the FDIC to maintain reserves equal to at least 1.25% of insured deposits. If the reserves decline below this ratio, the FDIC is required to increase its insurance premiums charged to banks to regain this minimum ratio. That is, the banks pay for any losses to the FDIC from protecting insured depositors in insolvencies that reduce the ratio below 1.25%.

In addition, banks must make up any losses suffered by the FDIC should it bail out uninsured depositors at insolvent banks that are deemed “too big to fail.” This could happen if the FDIC, in conjunction with the Federal Reserve, the Treasury Department, and the President, determines that not protecting these depositors would seriously destabilize the economy.

Thus, all losses to the FDIC are now paid for by the banks, not the taxpayer, unless the resources of the banking system as a whole are exhausted and the banks cannot pay the necessary additional premiums. But it is extremely difficult, if not nearly impossible, to imagine a crisis in the United States in which all the resources of the banking system are exhausted. It did not happen even in the 1930s or in the 1980s.

Deposit insurance is now effectively a privately funded system; the taxpayer is basically off the hook. But this may not last long. During the recent hearings, some regulators testified in favor of giving the FDIC more flexibility in changing premiums. Not requiring the banks to pay for the losses through higher premiums whenever the designated reserve ratio declines below 1.25% would probably put the taxpayers back on the hook..

Among other recommendations, the FDIC proposes increasing the maximum coverage of $100,000 per account. In principle, this would not be a good idea, because it would benefit relatively few depositors and reduce their reason to be concerned about the financial health of their banks. This would encourage banks to take more risks.

But because the banks themselves would pay for any resulting increase in losses, as well as any losses from invoking “too big to fail,” the issue is less of a public policy concern than before. There is no longer any significant public subsidy to banks from deposit insurance.

The FDIC also complains that it is not fair that some banks, in particular newly chartered and rapidly growing ones, now pay no insurance premiums. (They do not because the FDIC reserve ratio is effectively capped as well as floored at 1.25%, and it is now fully met.) However, most banks will pay premiums again when losses from failures push the ratio below 1.25%.

Thus, unlike the old structure, today’s fund is on a “pay-as-you-go” basis that focuses on post-settlement. The old system relied primarily on a fund that could be built up and then drawn down to finance losses. While there are advantages and disadvantages to either system, the old one did not automatically require premium increases, and so it put the taxpayer at risk.

Lastly, the FDIC would like to see the insurance premiums altered to reflect the riskiness of the insured bank, with some of its risk laid off on private reinsurers. While risk-sensitive premiums are standard in most private insurance systems, such as life and casualty, government deposit insurance is different. Most importantly, the loss to the FDIC from bank failures is largely under the control of the regulatory agencies themselves through enforcement of a closure rule.

If the agencies can resolve (for example, liquidate or sell) an institution before its equity capital falls below zero, as they are encouraged to do by law, the losses would accrue only to the bank’s shareholders, not to its depositors or the FDIC. If an institution is resolved only after its net worth is already highly negative (as in the case of Superior Bank FSB of Chicago), large losses would accrue to uninsured depositors and the FDIC.

Moreover, the riskiness of a bank and the probability of its failure are influenced by the degree of regulatory supervision imposed. The FDIC Improvement Act requires regulatory agencies to progressively intensify their supervision as a bank’s capital position deteriorates. The loss to the FDIC from a bank insolvency is determined at least as much by the agencies’ own actions or inaction as by the bank’s, and uncertainty about closure policies would complicate any transactions with reinsurers.

While not perfect, the structure of U.S. deposit insurance is far better than it was 10 years ago. Most importantly, the taxpayer is now almost totally off the hook for bank losses to the deposit insurance fund. The banks are required to pay for any losses to the FDIC that drive the reserve ratio below 1.25%. As a result, deposit insurance pricing and coverage are private issues rather than public ones.

But by focusing on these issues, the current review takes the chance of inadvertently reverting to the bad old system of taxpayer liability. The perfect may again become the enemy of the good.

The U.S. taxpayer deserves better!

Mr. Kaufman is a professor of banking and finance at Loyola University in Chicago and a co-chairman of the Shadow Financial Regulatory Committee.

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