BankThink

Will FDIC keep protecting failed banks’ uninsured deposits?

Although it's not widely known or well understood, since the IndyMac failure in July of 2008, the Federal Deposit Insurance Corp. has, whenever possible, protected uninsured depositors in failed banks from any loss.

While it has been 14 months since the last bank failure, another round of failures is a near certainty during the next recession, which may soon hit the U.S. economy. Whether Jelena McWilliams, the new FDIC chairman, will seek to continue the FDIC’s now well-established practice of protecting uninsured depositors when bank failures resume is unknown at this time.

The FDIC’s unstated, but quite evident, practice of protecting uninsured depositors against any loss stems from the widely televised runs on IndyMac that forced its closure in July 2008. A well-placed source told me after that fiasco that members of Congress told the FDIC never to let such a run happen again.

FDIC Chairman Jelena McWilliams
Jelena McWilliams, chairman of the Federal Deposit Insurance Corporation (FDIC), speaks during a Senate Banking Committee hearing in Washington, D.C., U.S., on Tuesday, Oct. 2, 2018. The hearing focused on implementation of a new law easing Dodd-Frank Act rules on community and midsize banks. Photographer: Andrew Harrer/Bloomberg
Andrew Harrer/Bloomberg

The FDIC protects the uninsured depositors in a failed bank by executing a purchase-and-assumption, or P&A, transaction whereby a healthy bank assumes all of the deposits — uninsured as well as insured — of the failed bank as well as some of its assets in return for a payment from the FDIC equal to the amount of deposits assumed minus the value of the assets assumed. Occasionally the acquiring bank will pay a small premium for the acquired deposits, which modestly reduces the cost of the failure to the FDIC.

The FDIC can protect uninsured depositors when doing so can be justified under the statutory least-cost resolution test. Given the highly subjective estimates that must be factored into this test, the FDIC apparently can justify protecting uninsured depositors in most failures.

Protecting uninsured depositors against any loss eliminates any complaints those depositors might have about how well the FDIC regulated the failed institution or managed the liquidation of the failed bank’s assets as a badly managed liquidation would increase the loss suffered by uninsured depositors. The FDIC’s management of the failed bank’s receivership also is greatly simplified.

Of course, protecting uninsured depositors against any loss will increase the FDIC’s expense in resolving the failed bank if its least-cost-resolution analysis for that bank is based on excessively optimistic assumptions. The banking industry will pay the additional resolution cost in the form of higher premiums.

The existence of the “no depositor loss unless absolutely unavoidable” practice is quite evident by contrasting the FDIC’s failed-bank resolutions before the IndyMac failure with its resolution practices since then.

Of the 127 banks and thrifts that failed from Jan. 1, 1993, to the last bank that failed before IndyMac was closed, just 39 of those failures were resolved through a P&A transaction.

For the other 88 resolutions, uninsured depositors suffered a loss because only insured deposits were paid off in full or another bank purchased or otherwise assumed just the insured deposits of the failed bank, leaving the uninsured deposits behind, in the failed bank’s receivership.

From the perspective of deposits, 71% of the total deposits of the 127 failures were in institutions where uninsured depositors suffered a loss, while 29% of the deposits were in institutions resolved through a P&A that fully protected uninsured depositors from any loss whatsoever.

The post-IndyMac resolution experience has been starkly different. Since IndyMac, there have been 522 failures, excluding Washington Mutual. Although its uninsured depositors suffered no loss, it has been excluded from the following data because its enormous size would distort the pre- and post-IndyMac contrast that is being drawn.

Of the 522 failures, just 31, or 5.9%, were resolved in a manner that only protected insured deposits — uninsured depositors were therefore put at risk of a loss. Those 31 banks and thrifts held just 4.9% of the deposits of the post-IndyMac failures.

In the other 491 failures, which held total estimated deposits of $286 billion at the time of failure, uninsured depositors suffered absolutely no loss. Additionally, because these failed banks were resolved through P&A transactions, the depositors and borrowers in these banks suffered minimal disruption in their banking and borrowing activities.

While smaller banks are less reliant on uninsured deposits than large banks, of the 144 failures since IndyMac with less than $100 million in deposits, just nine were liquidated with a loss to any uninsured depositors.

Bank liquidations designed to impose losses on uninsured depositors unfortunately have serious negative impacts on the failed banks’ depositors and borrowers through what effectively is a destruction of their banking relationships. That destruction not only hurts the bank’s customers, it can be especially harmful in small or isolated communities.

One notable, and widely publicized, example of a damaging bank liquidation, so that losses could be imposed on uninsured depositors, was the April 2009 closing of New Frontier Bank in Greeley, Colo. Many sound borrowers at that bank, especially those engaged in agriculture and agriculturally related businesses, were hard-pressed to establish new borrowing relationships at other banks.

The FDIC, though, has never stated the extent to which it takes into consideration the impact of a bank’s liquidation on its community and especially its businesses.

As the numbers clearly show, despite the widely advertised $250,000 insurance limit on deposits in FDIC-insured banks, most of the time the FDIC in recent years has ignored that limit when resolving a failed bank. So much for depositor discipline.

The fundamental policy question facing the FDIC today is whether that limit will continue to be ignored most of the time when the next wave of failures hits — or whether the FDIC will return to the pre-IndyMac days of imposing losses on uninsured depositors whenever possible.

If the FDIC reverts to its pre-IndyMac policy, it will be interesting to see the extent to which it publicly discusses that policy reversion.

For reprint and licensing requests for this article, click here.
Deposit insurance Deposits Consumer banking Jelena McWilliams FDIC
MORE FROM AMERICAN BANKER