Deposit Insurance a Persistent Problem

In the last really big U.S. financial bust, that of the 1980s, the nature and role of deposit insurance in creating the problems was widely and prominently debated. After the public admission that, on top of hundreds of insolvent thrifts, the Federal Savings and Loan Insurance Corp. was itself insolvent, Congress declared that deposit insurance was explicitly a full faith and credit obligation of the United States. This it had never previously been.

By contrast, the role of deposit insurance in the 21st-century bubble and bust was hardly discussed at all, except to keep increasing FDIC coverage and guarantees. Discussion picked up recently, as it became apparent that the FDIC's insurance fund was dramatically shrinking. Now that the FDIC has announced that it is insolvent--i.e., its net worth is negative--naturally it has become a hot topic. But it has not yet reached the point, as it did 20 years ago, of questioning the nature and wisdom of government deposit guarantees as a policy matter.

Federal deposit insurance was created by the Banking Act of 1933, under the guidance of the famous pair, Sen. Glass and Rep. Steagall, the chairmen of the respective banking committees. The following quotations are what they thought about the role of the government in deposit insurance, with a related explanation from another senator of the day.

The combination of riskless funding with risky businesses is inherently impossible.

Sen. Glass: "This is not a government guarantee of deposits. The government is only involved in an initial subscription to the capital of a corporation that we think will pay a dividend to the government on its investment. It is not a government guarantee."

Congressman Steagall: "I do not mean to be understood as favoring a government guarantee of bank deposits. I do not. I have never favored such a plan. Bankers should insure their own deposits."

Sen. Bulkley: "There was a very definite appeal from bankers for the United States government itself to insure all bank deposits so that no depositor anywhere in the country need have any fear . . . Such a guarantee as that would indeed have put a premium on bad banking."

Seven decades later, we find in all banks the current version of the FDIC sticker, which prominently features the commitment the creators of deposit insurance thought they were avoiding: "Backed by the full faith and credit of the United States government."

If we view the matter from the "30,000 feet" perspective, a fundamental contradiction involved in all modern financial systems is apparent.

On one hand, there is the fervent political desire to make deposits riskless for the public, so that depositors do not need to know anything about or care about the soundness of their bank. But their deposits fund businesses that are inherently very risky, highly leveraged and cyclically subject to much greater losses than anyone imagined possible.

The combination of riskless funding with risky businesses is inherently impossible. The attempt is made to achieve the combination through regulation, but this inevitably fails.

Governments are therefore periodically put in the position of desperately wanting to transfer losses from the banks to the public, as once again in this cycle. An alternative is to prefund the losses through deposit insurance. But because the losses can get bigger than the fund, it ends up needing a government guarantee, thus bringing the risk back to the public.

My good friend Bert Ely (and others) will argue, I know, that because the FDIC has the power to assess all banks for unlimited amounts, Steagall's idea that "bankers should insure their own deposits" is what we really have. But it is undeniable that what actually gives power to deposit insurance and stability to deposits is not the potentially unlimited assessment, but rather the explicit government guarantee.

Supporters of the Steagall idea should be willing to have the FDIC sticker revised to read: "Backed by the ability to assess all banks for an unlimited amount," and to remove all mention of the government's credit. I doubt they are willing to accept this revision.

Has government deposit insurance "put a premium on bad banking," as Sen. Bulkley warned it would?

Certainly in some cases it did, especially when risky, rapidly expanding real estate-lending banks could fund themselves by rapidly expanding brokered deposits.

More generally, did deposit insurance help inflate the real estate bubble, especially in commercial real estate? Without doubt, it did.

Leveraged real estate has been the cause of many banking busts. Over the past several years real estate loans of all commercial banks have grown to represent 56% of their total loans. For the 6,500 smaller banks, with assets under $1 billion, this ratio is a whopping 74%. This expansion of real estate risk could not have happened without deposit insurance.

The current FDIC discussions include some notable ironies. The FDIC has argued that its low net worth should be acceptable because it has large reserves for expected failures. Imagine a bank with capital approaching zero and reserves reflecting known losses making that argument to an FDIC examiner.

One recent forecast of the number of bank failures in this cycle is "hundreds and hundreds." Another is 500 banks--a more pessimistic one, 1,000. Of course these numbers now include thrifts. They do not look unreasonable compared with about 2,300 failures of banks and thrifts in 1986-92.

Make your own estimate of the number of failures and the cost to the FDIC, when failures in 2008-09 have been costing on average about 25% of the total assets of the failed bank. Then add the fact that the deposit insurance fund has to be built back up from less than zero to 1.15% of an expanded base of covered deposits in time to be ready for the next cycle.

The only possible conclusion is that this is going to be very expensive indeed for the banking industry, with the taxpayers still on the hook for their guarantee.

The FDIC Improvement Act of 1991, based on the lessons of FSLIC and the 1980s, was thought to have solved the problems of deposit insurance. Obviously, it didn't.

Alex J. Pollock is a resident fellow at AEI.

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