From all appearances the rebuilding of the Federal Deposit Insurance Corp.'s finances is turning into one of the few feel-good, postcrisis stories. But banks should not jump to the conclusion that FDIC coffers are necessarily strong enough to handle the next wave of failures.
The Deposit Insurance Fund held a record $67.6 billion in June, a nearly 30% increase from pre-crisis levels. There were huge industry costs, to be sure, in digging the fund out from a bank-failure-induced insolvency. But thanks to continual assessment fees paid every quarter — including funds the industry prepaid — and the obvious slowdown in failures, the FDIC is well in the black.
Even more heartening for the industry, thousands of community banks can soon expect a premium cut. The agency, which in June said DIF reserves were 1.06% of insured deposits, projects the reserve ratio will hit 1.15% next year — earlier than projected. Once that trigger is hit, under the FDIC's "restoration plan," smaller institutions will see a reduction by as much as 30%.
Under a recent agency proposal, most large banks would have to pay a surcharge for two years to boost the ratio to 1.35%, the statutory minimum established by the Dodd-Frank Act. But once the ratio reaches that point, large banks too would enjoy the reduction. Whereas healthy banks now pay on average around 7 basis points times the difference of assets and tangible equity, that figure is expected to drop to about 5 basis points over the long term. A bank's actual rate is determined by a variety of risk-based factors.
Not surprisingly, industry representatives have responded positively to the progress. "The FDIC insurance fund is now larger than it has ever been, and will meet the congressionally mandated levels much sooner than had been expected," American Bankers Association Chief Economist James Chessen said in February.
So why shouldn't the industry start celebrating? For the simple fact that the fund is in roughly the same position that it was right before the crisis. This means that should another shock occur as in 2008, and the FDIC suddenly were hit with a wave of failures, the DIF's net worth could theoretically fall below zero just as quickly as it did right after the subprime meltdown.
Not that this scenario is likely. Based on economic projections and the state of banks' credit portfolios, the chance of another wave of failures in the near term is pretty remote. The agency took a negative loss provision for five consecutive quarters through June 30, meaning that it had essentially returned money to the DIF based on lower failure projections.
But the FDIC's fund is still far from what the agency itself considers adequate in the event of a catastrophe. So, despite the upcoming discount, banks might need to plan on paying steadily for possibly more than a decade for the fund's reserve ratio to hit the FDIC's long-term target of 2%. The FDIC has long been interested in expanding the fund enough in good times so that it can fall in a crisis without moving to a deficit and without the need to charge banks exorbitant premiums to restore it. But the agency has a ways to go.
To illustrate what I'm talking about, assume the fund did experience again the kind of sharp drop it did from 2007 and 2009. Before that dip, the fund balance was $52.4 billion, with a reserve ratio of 1.22%, 16 basis points higher than the most recently reported ratio. Seems healthy, right? But within two years all of that net worth was gone. The balance plummeted by $73.3 billion to -$20.9 billion, with a reserve ratio of -0.39%.
This is a good point to bring up the fact that the agency never ran out of cash during that period. A significant driver of the agency's capital position is the separate loss-reserve account it must maintain when it projects a future increase in failures. Even though the fund showed a negative net worth in the crisis, that was due in large part to the agency's huge loss provisions.
Still, the failure wave stoked fears about the agency's financial standing and whether the FDIC might need to tap its credit line with the Treasury Department for the first time. To get the fund on surer footing, the FDIC in 2009 borrowed three years of estimated premiums from the industry, what was called a "prepayment." After the fund stabilized, the agency started to rebate fees that exceeded the estimate.
This is unscientific war-gaming, but if the FDIC were suddenly hit with a similar obligation to handle failures, the current fund balance of nearly $68 billion could shoot down to -$5.7 billion in two years. Poof, just like that. The reserve ratio, based on estimated insured deposits at the end of the second quarter of this year, would fall to -0.09%.
The agency's 2% target ratio — known as the "designated reserve ratio" — is 65 basis points higher than the statutory minimum. It is a nonbinding goal — so the FDIC can apply brakes if it wanted to — but that target is one the agency says it would need to reach to strengthen the fund's long-term health.
"A 2% [designated reserve ratio] is an integral part of the FDIC's comprehensive, long-range management plan for the DIF. A fund that is sufficiently large is a necessary precondition to maintaining a positive fund balance during a banking crisis and allowing for long-term, steady assessment rates," FDIC staff said in an Oct. 6 memorandum to the agency's board of directors. It recommended that the target ratio stay at 2%.
Getting there will take time. In 2010, when the FDIC first set the higher target, agency officials estimated it would take until 2027 at the earliest to hit 2%. Before the crisis the agency's designated reserve ratio was 1.25%. But that level was too low to maintain a positive fund balance during the crisis.
A 2% target "is certainly better grounded than 1.25%, which obviously proved to be woefully inadequate," then-FDIC Chairman Sheila Bair said at an October 2010 board meeting.
That the fund roared back after the crisis is a credit both to the industry and the FDIC. But efforts to ensure the long-term health of the deposit insurance system are really just back to square one.
Joe Adler works in American Banker's Washington bureau and is the editor of BankThink. The views expressed are his own.