If Two Tiers Work for Regulation, Why Not Deposit Insurance?

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A former Federal Deposit Insurance Corp. chair is now calling for a two-tiered legislative solution that could significantly reduce the regulatory burden on community banks. This approach "might give regulators the ability to craft simpler rules for banks with much simpler business models," former FDIC head Sheila Bair said in a February interview with American Banker. "It's clean, simple, easy to write … I don't know why anyone would object to it."

I agree: I don't know why anyone would object to it. I also don't know why any community banker or taxpayer would object to applying this same premise to FDIC deposit insurance by separating the risk concentrations that exist within the fund. Perhaps a look back into the history of the deposit insurance fund offers some perspective on why this approach merits consideration.

The Federal Deposit Insurance Corporation Improvement Act was enacted in 1991 as the industry reeled from the bank failures of the 1980s. The law restructured the entire deposit insurance system and changed the assessment process from flat-rate premiums to risk-based premiums. Obviously, lawmakers realized that all banks did not pose the same risks to the fund and made a distinction in risk profiles and premiums for the first time.

The FDICIA was also notable for formally recognizing the term "too big to fail," although the term "TBTF" first rose from the ashes of Continental Illinois National Bank in 1984. The law established procedures to be followed in determining whether an institution posed too great of a systemic risk to allow its failure. TBTF has since been a major point of discussion and controversy.

As required by the Dodd-Frank Act, the FDIC began assessing banks based on their assets rather than deposits. At year-end 2014, over 99.5% of the insured institutions — or 6,486 banks — comprised only 36.5% of the total assessment base. Conversely, less than .5% of the institutions — 23 large institutions — represented 63.5% of the total assessment base. It's safe to say that all banks do not pose the same level of risk to the fund, as was recognized with the implementation of FDICIA.

Dig a little deeper. At year-end 2014, the biggest four bank holding companies held assets totaling $8.2 trillion. They are JPMorgan Chase ($2.6 trillion), Bank of America ($2.1 trillion), Citigroup ($1.8 trillion) and Wells Fargo ($1.7 trillion). These institutions hold 1.5 times the total assets of the remaining top 50 banks combined. To put it in perspective, the collapse of Washington Mutual in 2008 represents the largest bank failure in U.S. history. However, JPMorgan Chase is over eight times larger than Washington Mutual was at closure ($307 billion).

Ironically, WaMu's banking operations were acquired from FDIC receivership by none other than JPMorgan Chase. The list of candidates with the capacity to acquire WaMu was a small one. A list of candidates with the capacity to acquire the big four doesn't exist.

At the beginning of the financial crisis in mid-2008, the big four banks held 33% of the total reported assets of all insured institutions. As of December 2014, they held 42% of the total $15.6 trillion in total reported assets of all FDIC-insured institutions. The concentration and exposure in the deposit insurance fund continues to grow while TBTF celebrates its healthy, unchallenged 30 years of existence.

Former Federal Reserve Chairman Alan Greenspan is widely credited as the master of "Fedspeak." He could make the simplest subject matter sound so ambiguous and confusing that his audience would argue over interpretations. However, in 2009, Alan Greenspan may have made one of his simplest statements ever regarding TBTF: "If they're too big to fail, they're too big."

Moral hazard occurs when one party takes more risks because someone else bears the burden of those risks. Clearly, the smaller banks in the deposit insurance fund are subsidizing the activities of the largest banks. The insurance fund effectively insures compacts and Ferraris under the same basic premium structure, with no consideration for systemic risk. There is no logical justification for placing a small-town community bank in the same risk pool with a complex megabank, requiring them to subsidize various activities that they don't engage in or even understand.

At year-end 2014, 98% of the 6,509 insured institutions reported under $10 billion in assets. This needn't be the threshold in a two-tiered system, but it is a good place to start the discussion — and also happens to be the same cutoff Bair references in her proposal.

Smaller, less-complex banks would eagerly support participating in an insurance fund with others who bring the same basic operational risks to bear, even if their assets exceed a certain threshold. The existing risk-based premium structure could account for capitalization, "Camels" ratings and other traditional measures of performance and soundness.

The larger, more complex institutions would then be left to subsidize and support each other in a separate systemic risk pool or go it alone. This would be a big first step in addressing moral hazard and TBTF. The burden of responsibility for the largest banks' riskier activities and increasing asset concentration would shift from the subsidizing smaller banks and taxpayers to the depositors and counterparties of those complex institutions.

This is certainly not a new or novel solution to an old problem. However, it would be similar in concept to Bair's recent promotion of simpler rules for banks with simpler business models.

Bair suggests that legislation implementing a two-tiered regulatory system for banks would be clean, simple and easy to write. I am not so sure the same approach with deposit insurance would be easy to write, but it could be clean and simple. And while large, complex banks would surely object to a tiered approach for deposit insurance, traditional community bankers and taxpayers would rejoice.

Joseph H. Neely is a former director of the FDIC. He is president of Neely and Associates, a consulting firm providing advisory services to community banks.

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