On Sept. 29 the Federal Deposit Insurance Corp. proposed that banks prepay their deposit insurance assessments for the fourth quarter of 2009 and all of 2010-2012. If approved, the plan would immediately require all insured banks to pay roughly $45 billion into the deposit insurance fund, which has dwindled to $10.4 billion in unallocated funds.
However, not enough attention is being paid to whether this amount will be sufficient because the economic consequences have not been considered.
In our view, this infusion is likely to be too little because, if the FDIC requires it, more banks would see their financial condition decline on reduced earnings and liquidity. Less credit would be available overall, the economy would be weaker than anticipated, and job creation by small businesses, as seen in typical recoveries, would not be there. Finally, bank failures would probably exceed expectations, imposing higher costs on the FDIC.
Two strong economic negatives come with the FDIC's prepayment plan. First, it would adversely affect the liquidity of many small banks, which have gotten no federal assistance to date. Because regulators are encouraging these banks to increase their liquid assets and pay down brokered deposits and FHLB advances, these banks would probably replace any funds advanced to prepay premiums with new holdings of cash equivalents, funds that could be used to make loans, invest in securities or pay down debt.
The immediate effect would be lower earnings. Moreover, given today's regulatory focus on the net noncore funding dependency ratio (difference between noncore liabilities and short-term investments divided by long-term assets), forcing community banks to prepay insurance generally makes banks look worse in terms of liquidity risk.
On top of this, the FDIC has greatly expanded the assessment rates applied to a bank's insured deposits, now ranging from 7 basis points to 77.5. The actual rate levied depends on a combination of a bank's capital ratios, its supervisory Camels rating and its reliance on funding from unsecured debt, secured liabilities and brokered deposits.
Even without the prepayment plan, many community banks already pay higher premiums today than in recent years either because their composite Camels ratings have been downgraded or they rely on brokered deposits, Federal Home Loan Bank advances or other secured liabilities. It is important to recognize that these higher premiums reflect the impact of economic conditions caused primarily by large financial institutions and the shadow banks.
Second, the potentially adverse economic effects are likely to be significant. Small communities throughout the country rely heavily on their local banks to supply credit to small businesses and individuals — the engine that allows our national economy to grow. These local banks often are the only source of credit for many small businesses. Unlike larger institutions, few community banks got Tarp capital injections, and most were unable to take advantage of the FDIC debt guarantee. Forcing these community banks to prepay expenses reduces their ability to lend which, in turn, reduces credit availability. Because small businesses are the primary sources of new jobs, it does not make economic sense to place a greater burden on them.
As proposed, the plan lets banks with liquidity problems request an exemption from the prepayment requirement. Remember that 416 banks were on the problem list at the end of June 2009 and this total had probably grown a lot by September. Will all of these institutions get exemptions? Even if all problem banks are exempted, significant moral hazard problems arise because banks that are deemed financially riskier would have more lending flexibility than banks that successfully navigated the crisis.
The FDIC has the authority to borrow $100 billion from the Treasury, and another $400 billion is potentially available, with congressional authorization. Politically, the FDIC would like to avoid the perception that it is relying on taxpayers for assistance. However, the real problem is that the FDIC did not build the DIF during good economic times. Because this was not done, the FDIC now proposes to harm banks economically just as the country is trying to recover from the financial crisis. This is poor economic policy!
The primary advantage of FDIC borrowing from the Treasury is that it creates economic benefits relative to all other alternatives. The U.S. economy would have much better prospects if this action were taken, as opposed to forcing commercial banks to pony up $45 billion now.