A cautionary tale on brokered deposits

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The Federal Deposit Insurance Corp. is considering changing its rules governing brokered deposits, as American Banker recently reported. A number of bankers have urged the FDIC to liberalize the current rules so they might fund their banks more readily and extensively by purchasing money from deposit brokers. I would caution bankers and the FDIC to tread cautiously in this area.

Extraordinarily high interest rates during the late 1970s and early 1980s — when the prime lending rate reached a high of 21.5% — caused a massive outflow of deposits from banks and thrifts into money market funds, Treasury bills and other investments paying higher interest rates than banks and thrifts. Congress and the regulators were forced to eliminate deposit interest rates controls on banks and thrifts to prevent a meltdown of the industry due to massive deposit disintermediation.

Regrettably, deregulation of interest rates on deposits of $100,000 and above gave rise to the practice of money brokers raising vast sums of money from individuals, businesses, and even credit unions and bundling the funds for sale to the banks and thrifts that bid the highest price, which were nearly always the banks and thrifts that had the highest risk profile.

As the bank failure rate began its dramatic rise, we found an increasing number of failed banks had large amounts of fully insured brokered funds. We felt we had to take strong actions to stop this massive abuse of the deposit insurance system, which was intended to protect relatively small, unsophisticated depositors, not institutions sweeping up billions of dollars from investors to fund the reckless growth of high-risk banks and thrifts.

We addressed the problems on every front available to us, including publicizing the amount of brokered funds in each failed bank and naming the brokers that placed those funds. We took enforcement actions against banks making excessive use of brokered funds.

Our strongest and most controversial action was to adopt a regulation eliminating “pass-through” deposit insurance coverage on deposits by brokers. In short, we treated the broker as the depositor, not the broker’s customers. This meant that if a money broker placed $200 million in a bank, the broker was limited to $100,000 of insurance coverage.

Our intention was to allow the free market to operate. The brokers were sophisticated firms that were perfectly capable of analyzing the condition of the banks and thrifts in which they were placing vast sums of money. They could weigh risk versus reward, unlike the smaller depositors that the FDIC was created to protect.

Money brokers contested the FDIC’s new regulation through every available means, including an intense media campaign and litigation. Regrettably, the Court of Appeals for the District of Columbia sided with the money brokers and ruled that the FDIC did not have the authority to interpret its law in this manner.

The floodgates were open. Money brokers raised hundreds of billions of dollars, collecting fees from investors. They placed the money in troubled banks and thrifts, collecting placement fees. Then they asked or required the recipient banks and thrifts to purchase junk bonds issued in corporate takeovers arranged by the money brokers and their friends.

It was the worst taxpayer scam in history, at least up to that point. We do not have accurate data because the FDIC stopped collecting the information after I left the agency at the end of 1985. But I have no doubt that the brokered deposit/junk bond scam needlessly cost taxpayers many tens of billions of dollars in the S&L fiasco.

It did not need to happen. We saw the problem coming, and we reacted to it quickly and strongly. We pleaded for help from Congress and got none. After taxpayers footed the $150 billion bill for cleaning up the S&L mess, Congress finally addressed the brokered deposit issue. It restricted the use of brokered funds by banks and thrifts that fell to unsatisfactory capital levels. In other words, Congress allowed the regulators to close the barn door after the horses were gone.

Here we sit over 30 years after this problem surfaced and after it again caused very substantial losses to the FDIC in the latest crisis. When are we going to summon the courage to solve this problem?

I know that the usage of brokered funds has become more sophisticated and complex in the past decade or two, but surely we can find ways to substantially curtail the abuses. With the deposit insurance limit now set at $250,000 there is even less justification to allow schemes to further expand the coverage.

Good bankers running sound and profitable institutions will inevitably bear the cost of expanding FDIC coverage of brokered deposits. Broker activity will run up the cost of funding for all banks and many banks will engage is higher-risk lending to cover the higher cost of funding. And when the next downturn comes, the FDIC will incur more substantial losses, which the sound banks that survive will be required to absorb.

The banking industry was forced to cover the $150 billion cost of cleaning up the S&L industry in the 1990s. Do bankers really want to go back to that future?

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Deposits Consumer banking FDIC