The government has announced steps to increase protection for bank creditors, and though I support the general thrust of the moves, they present substantial issues and unintended consequences.
I believe the FDIC should use its emergency powers to declare that during the current crisis it will handle bank failures in a manner that will protect all general creditors of banks (with a fraud exception). This is the simplest and most effective way to calm financial markets and maintain stability of funding in the banking industry.
Instead, the government has taken and proposed a series of actions that could haunt the industry for years to come.
Increased deposit insurance. Congress recently authorized a one-year increase in the deposit insurance limit to $250,000. I argued that the increase would be insufficient to calm the markets and unfair to small banks.
The increase did not calm the markets, so let's turn to the fairness issue. Everyone knows that creditors of the largest banks will be fully protected. Moreover, the Treasury Department provided 100% coverage to money market funds and protected all creditors of American International Group. In light of these facts, how do we justify limiting smaller banks to $250,000 coverage during this crisis? I can't.
Moreover, I'm confident the $250,000 limit will not be allowed to expire. If I'm correct, then we will have permanently increased the cost of deposit insurance. Because small banks rely more heavily on insured deposits than large ones, small banks bear a disproportionate share of the cost.
Full protection for checking accounts. After increasing the insurance limit to $250,000 proved inadequate, the FDIC announced it would fully insure checking accounts that do not bear interest for one year. The program is bound to cause considerable customer confusion, as it is voluntary and does not cover sweep accounts.
My bet is that we will not be able to get rid of this coverage, which will further increase the cost of deposit insurance. The cost will likely fall disproportionately on small banks.
Guarantee of debt. The FDIC also decided to guarantee new issuances of bank debt for three years — including interbank funding and holding company debt (apparently including debt from Goldman Sachs and Morgan Stanley). The program is voluntary, and the FDIC will charge an annual fee of 75 basis points.
How will customers know which banks are participating in the program and whether the debt instruments they are buying are guaranteed? There is a limit on the amount of the debt the FDIC will guarantee per bank. How will a buyer of debt know if that limit has been crossed?
How much pressure will this program put on banks that cannot participate? It could be the death knell for firms that might otherwise survive. What are we going to do if a large amount of this debt matures in three years and the markets are unwilling to replace some or all of it without the guarantee?
I understand the charge for the guarantee will be in the $10 billion range annually. Is it sound for the FDIC to extract $30 billion of capital from banks over the next three years at the same time the government is investing $250 billion in banks to boost lending capacity? Is it fair to charge banks that have paid into the FDIC fund for decades the same fee as holding companies, which have never paid into the fund?
If the FDIC would instead simply announce that it will treat all bank failures alike during this period of crisis — i.e., that all general creditors of banks will be protected when a bank fails — I believe we would obtain much better results.
Bank failures would be reduced, because funding would be more stable, and marginal banks that might recover would not be pushed over the edge. The playing field would be leveled among banks of all sizes. The rules would be easy to understand — there would be no confusion about which banks, instruments, and accounts are guaranteed.
When the crisis subsides, the FDIC would simply withdraw its emergency declaration; there would be no arbitrary deadline on when this occurs. Customers of banks would not have gotten hooked on the opium of higher deposit insurance limits, and banks would not bear the burden of permanently higher deposit insurance costs.
The current plan and the alternative I am suggesting both entail increased moral hazard. In either case, regulators will need to be diligent to ensure that banks are not taking advantage, and some banks will need to be put out of business.
I believe the alternative plan involves less risk for the FDIC because it would lower the failure rate, it does not cover holding company debt, creditors of banks holding 70% of the industry's assets already have de facto full coverage, and the increased moral hazard would end whenever the emergency abates.
Equally important, this would be a more balanced and fair approach focused on Main Street as much as Wall Street.