The recent debate over "too big to fail" misses the point that it is a symptom of a much bigger unsolved problem, namely the need for real deposit insurance reform.

Besides dealing with TBTF banks, such reform would also address the risks to the Federal Deposit Insurance Corp. and ultimately the taxpayer of the nearly 400 failed banks during the financial crisis, especially de novos, rapidly growing banks and those with concentrations of subprime or other high-risk assets.

With all due respect to the FDIC, it has a dismal record as an insurance corporation, with its fund effectively gone insolvent not once but twice (in 1991-92 and more recently during 2009-11). Banks can't go insolvent twice, so why should their insurer?

The FDIC apparently has forgotten about the "corporation" in its name and acts more like a government agency that's been captured by the industry it regulates. That is, the FDIC primarily responds to the interests of the banking industry from which it derives its premiums rather than the depositors and taxpayers who ultimately back the FDIC through its line of credit with Treasury and the government's full faith and credit.

What would real deposit insurance reform look like?

Real deposit insurance reform focuses on insuring depositors (not banks) and ultimately taxpayers backing the system against loss resulting from bank failures. This is consistent with the purpose of the FDIC as stated in its first 1934 annual report.

The bank depositors' view of deposit insurance reform puts the "Corporation" back in the FDIC so it acts more like a real insurance company rather than a government agency:

  1. The statutory minimum Designated Reserve Ratio should be increased to at least 1.5%, so that figure becomes the floor rather than the ceiling. The Dodd-Frank Act raised the minimum to 1.35% from 1.15% and allowed the FDIC to rebate amounts above 1.5%.
  2. There should be NO cap on the size of the DRR or the insurance fund. It is true that Dodd-Frank removed the statutory cap, but 1.5% could become the ceiling in practice, since the law still allows the FDIC to pay rebates above that level.
  3. NO rebates should be paid to banks even in the best of times. Granted, the FDIC issued a rule in 2011 indefinitely suspending such "dividends," saying it would instead lower assessment levels if the ratio climbs above 2% and lower them again should the figure exceed 2.5%. (The recently announced $6 billion refund is for an extraordinary prepayment of premiums during the crisis.) But, like any insurance corporation or bank the FDIC must build up reserves during good times since there will be future crises that may again threaten the fund's solvency. Banks, conflicted by moral hazard, will always fight for maximum FDIC coverage at the least possible cost, since the FDIC is ultimately backed by Other People's Money.
  4. The deposit insurance limit should never have been raised above $100,000. It should be lowered to that level from the current $250,000. We must continue to reduce the federal safety net in the same way we eliminated unlimited temporary transaction account coverage. This encourages market discipline by depositors who will more carefully monitor bank risk. The FDIC was established to protect "small savers," and $100,000 coverage per account, with the option of having multiple accounts, does that. The Federal Reserve Board's most recent 2010 Survey of Consumer Finances shows the median transaction and CD balances for all families holding assets at $3,500 and $20,000, respectively, with the comparable levels for those in the wealthiest 10% by net worth at $60,800 and $65,000.
  5. In addition to regular premiums, special risk deposit premiums should be annually assessed in a 3- to 10-basis-point range for banks with a targeted risk profile such as those with subprime lending or rapid growth as well as de novo financial institutions. Using the minimum 3-basis-point assessment, a rapidly growing de novo bank making subprime loans would have at least a 9-basis-point annual special assessment.
  6. A 3- to 8-basis-point special assessment for TBTF banks based on total assets rather than deposits. A rapidly growing TBTF bank with a relatively small insured deposit base but a subprime lending affiliate would pay the highest 8-basis-point annual premium plus the 6-basis-point special risk assessments for rapid growth and subprime lending.

My TBTF special assessment proposal follows from the four TBTF "facts of life":

  1. TBTF has existed since 1984, when the government intervened in the collapse of Continental Illinois.
  2. TBTF cannot be eliminated
  3. TBTF is an extremely valuable competitive advantage and benefit to the banks in this exclusive club
  4. TBTF banks pay nothing for this privilege

Realizing that nothing can be done about the first three facts, good public policy dictates a TBTF assessment. Unlike increased capital requirements, which banks can delay, dilute or dodge, a meaningful TBTF assessment immediately affects quarterly profits, which is what big bank CEOs and their shareholders really care about.
Why didn't the FDIC adapt real deposit insurance reform?

The above deposit insurance reforms likely would have prevented the insurance fund from going into the red a second time. But, they were never seriously considered because the FDIC and its congressional overseers answered primarily to banks rather than depositors.

I proposed all the above reforms and laid out the TBTF "facts of life" in 1995 and again in 2000 (when the insurance limit was still $100,000) in testimony before the FDIC and Congress. These proposals were called "outrageous" by a former FDIC Chairman and the largest banking trade association in 1995.

Yet rather than increasing the statutory DRR minimum to 1.50%, the 2005 FDIC Reform Act reduced it to 1.15%. Most banks paid no premiums for years, and many received rebates and credits. Needless to say there were no special assessments for subprime lending, new, rapidly growing, or TBTF banks.

Can you think of another insurance corporation faced with unknown and potentially huge risks that does not charge premiums, gives rebates, and fails to build up its reserves during good times? The recent crisis has caused the FDIC and Congress to rethink some of these positions, but it has been too little, too late.

After two decades of research I have concluded that real deposit insurance reform (including a TBTF fix) is not possible as long as the FDIC and Congress primarily respond to the interests of the banking industry rather than the banking public.

Kenneth H. Thomas, an independent bank consultant and economist, was a lecturer in finance at the University of Pennsylvania's Wharton School for more than 40 years.