FDIC's brokered deposit proposal has a glaring problem

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A Federal Deposit Insurance Corp. proposal to modify the brokered deposits definition — established well before online banking — is understandably in need of an update. But some aspects of the proposal go too far and should be cut back.

And that’s saying something as a former director of the Consumer Financial Protection Bureau (and former member of the FDIC Board) who’s joined the former president and CEO of the Independent Community Bankers of America on this topic.

We come from different perspectives and haven’t always agreed on key issues. But we both fear the same thing now: that in the name of making brokered deposit rules simpler, the agency’s proposal will instead jeopardize financial stability while aiding larger banks at the expense of smaller banks.

To assess the proposal, one must recall why brokered deposits were restricted in the first place.

In the early 1980s, troubled banks began using deposits obtained by brokers to grow (assets) out of their problems. These deposits were “hot money” meaning; banks obtained them by offering higher interest rates. But these deposits could leave just as suddenly as arrived, which was destabilizing.

This was a large reason the FDIC, taxpayers and the industry had to pay more than $160 billion (or more than $300 billion in today’s dollars) to clean up the savings and loan crisis.

As a result, Congress forced the FDIC to place limits on brokered deposits. And for the most part, these limits have worked.

The FDIC has repeatedly found that brokered deposits increase the risk and cost of bank failures. In a landmark 2011 study under FDIC Chair Sheila Bair, the agency found that the 2008 crisis would have been even worse and more costly without restrictions on brokered deposits.

While we understand the desire to modernize the rules around brokered deposits, key safeguards that protect the financial system and taxpayers remain essential. The chief defect of the FDIC’s proposal lies in wrongly treating certain accounts the same as traditional core deposits.

For example, under current rules, cash sweep accounts by unaffiliated institutions — with no direct relationship to the bank — are considered brokered deposits. That is sound policy.

Unaffiliated deposits are the very definition of “hot money,” which moves very easily from one bank to another depending solely on fluctuating rates and other fleeting considerations.

But the proposal would exempt unaffiliated sweep accounts from regulatory limits, effectively treating it like safe, core deposits. This is a dangerous mistake. If this provision is adopted, it will subvert the main purpose of brokered deposit restrictions and potentially contribute to yet another financial crisis.

But you don’t have to take our word for it. In its 2011 study, the FDIC warned that unaffiliated sweep accounts are volatile and insecure, and can allow a bank to grow too quickly.

These accounts also have no franchise value, so any bank that relies on it and fails would have a hefty price tag for its collapse — a cost borne by the rest of the industry.

Another problem is that if the FDIC treats unaffiliated sweep accounts the same as core deposits, big banks and brokerage firms stand to benefit.

Stripped of their regulatory safeguards, these accounts would become more valuable and the entities that sell them to unaffiliated banks could charge higher rates. The availability and use would also increase, leading risky deposits to pile up, magnifying risk to the financial system.

It gets worse. As we know well, many banking regulations are interconnected, so changes have ripple effects.

Federal regulators, for example, generally treat brokered deposits as riskier than traditional deposits under the liquidity coverage ratio rule, which requires banks to be able to withstand a short-term crisis.

If the FDIC changes its treatment of unaffiliated sweep accounts, this modification could spur corresponding changes in the liquidity coverage ratio, reducing this safeguard for the biggest banks even though the “hot money” remains just as risky as before.

We fail to see why this proposed change is even being contemplated. The FDIC has not explained its about-face from its consistent research demonstrating why unaffiliated brokered deposits are less stable and pose more risks than core deposits (or even affiliated deposits).

While simplifying the rules around brokered deposits is a laudable goal, this change would trade simplicity for heightened risks. This central piece of the analysis must be addressed in any final rule, and unaffiliated sweep accounts should still be treated as brokered deposits.

In short, the FDIC must continue to ensure that hot money does not pose a significant threat to the financial system and to taxpayers.

Recent technological changes have not made it any less dangerous than it was in the 1980s. If anything, technology has made it even more volatile. We should not sow the seeds of a future crisis by repeating the mistakes of the past.

Richard Cordray is a former director of the Consumer Financial Protection Bureau. Cam Fine is a former president and CEO of the Independent Community Bankers of America. The opinions expressed are their own.

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