Both Federal Reserve Chairman Alan Greenspan and Treasury Secretary Lawrence Summers recently expressed serious objections to increasing federal deposit insurance coverage. And with good reason.

As they said, increasing coverage from $100,000 to $200,000, as some have proposed, would subsidize the wealthy and encourage excessive risk taking by banks as the government absorbs more losses upon a bank's failure. But the objections should not stop there, because current government policy may already subsidize the wealthy and distort market forces.

Specifically, the largest banking organizations in the country are likely to be seen as "too big to fail." The large and uninsured creditors of these organizations may think that the government will protect them from losses even if their bank fails. It is precisely these cases where creditors may benefit from much more than $100,000 government coverage.

Rather than ending the discussion, the objections raised by Mr. Greenspan and Mr. Summers should lead policymakers to make deposit insurance reform for the largest institutions a top priority.

What kinds of reforms in deposit insurance and bank regulatory policy should policymakers explore?

First, they must seek credible ways of putting uninsured creditors of these large banking organizations at risk of loss. Simply stating that uninsured depositors or bondholders will lose money is probably not enough. We need to enforce policies that convince creditors they will suffer losses if their bank fails.

Such policies could, for example, force all uninsured creditors to bear at least some loss but not require that they be wiped out completely when a bank fails. Alternatively, policies could require banking organizations to have subordinated creditors who are less likely to be protected by policymakers because they are sophisticated and are, by law, nearly last to make recoveries from a failed bank. Once at risk of loss, these creditors would have better reason to accurately price this risk. As noted below, regulators and the Federal Deposit Insurance Corp. could then harness the price signals generated by attentive creditors to discourage excessive risk taking.

Second, the FDIC and policymakers should alter the current rules governing deposit insurance pricing for the largest banks. The rules should set premiums that capture the potential for claims from the largest banks.

The current pricing rules have serious flaws. The FDIC is forced to virtually give away deposit insurance because of rules that limit the reserves it can hold. An insurance regime that does not charge premiums cannot discourage the insured from acting in ways that increase their chance of making a claim. Even when it could charge premiums, the FDIC did not use its discretion to force banks with a higher risk of loss to pay much more than banks with lower risk. Premiums should reflect risk.

Third, the FDIC must use market information to set prices according to the riskiness of an insured institution. We believe the improved prices established by creditors put at risk of loss could supply this information. Risk-based insurance pricing is crucial because deposit insurance coverage will persist, and as a result we know that banking organizations will not face the full extent of the market's discipline. Instead, regulators and the deposit insurer must incorporate market signals into the systems they use to manage bank risk taking.

Another potential source of market assessment of bank risk taking is the ever-expanding private insurance market. The last several years in particular have seen significant strides in the use of financial instruments, such as so-called "catastrophe bonds," that shift the loss arising from a major calamity to investors. This has increased the capacity of private markets to handle massive claims, and it offers another venue for risk-based pricing. The FDIC could explore the potential for shifting some of its exposure to the largest banks to private investors who would have incentive to price such potential loss.

In summary we agree that there is no compelling argument for raising deposit insurance coverage. However, we would go further and examine the current insurance system for cases in which too much coverage, even of an implicit sort, already exists, and we would take steps to curb it.


Mr. Stern is president and Mr. Feldman is an assistant vice president of the Federal Reserve Bank of Minneapolis. The views expressed herein are not necessarily those of the Federal Reserve System.

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