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Senator Chris Dodd’s regulatory expansion bill contains a particularly great expansion of regulatory power over large financial companies, giving the Federal Reserve wider jurisdiction and regulators jointly the power to order a liquidation administered by the Federal Deposit Insurance Corporation (FDIC), which would be financed by a $50 billion fund built up in advance by assessing large financial firms.
The model for these ideas is obviously deposit insurance and the FDIC. But how attractive a model is that?
Consider the Bloomberg headline, “FDIC Is Broke.” Indeed, the FDIC fund is insolvent, with a net worth of negative $21 billion as of the end of 2009. When the fund had about $50 billion, it was judged more than adequate. As the FDIC’s deficit net worth continues, numerous banks continue to fail. By some estimates, there are several hundred bank failures yet to go in this cycle, and the losses to the FDIC as a proportion of failed bank assets are running greater than the historical experience.
The result is that the FDIC is completely dependent on its guaranty from the U.S. Treasury.
Another experiment with deposit insurance, the Federal Savings and Loan Insurance Corporation (FSLIC), ended in deep insolvency and was abolished in 1989, passing about $150 billion in losses to taxpayers. By the way, taxpayers are still paying on the bonds issued to finance that bailout of 20 years ago.
Regarding its new proposal for a government fund, the Senate Banking Committee says, “Industry, not the taxpayers, will take a hit for liquidating large, interconnected financial companies.” Have we heard that before? Yes. Here’s what Henry Steagall, cosponsor of the original deposit insurance act, declared in 1933: “I do not mean to be understood as favoring the government guaranty of bank deposits. I do not. I have never favored such a plan. Bankers should insure their own deposits.”
But the government has had to guarantee both FSLIC and the FDIC, anyway.
It might be thought that the FSLIC and savings and loan experience is not relevant to current problems because the S&Ls were so concentrated in real estate. This thought would be wrong. The entire banking system today has an extreme concentration in real estate risk, which has been consistently building up since the mid-1970s, although the FDIC and the Fed have been regulating away all the while. (See “Lenders’ Dangerous Game in Real Estate.”)
How did the banks get their hands on so much money to bet on real estate? Through deposit insurance and the FDIC, of course, which makes the providers of deposits to banks completely indifferent about what the banks are doing with their money. This is the notorious “moral hazard” problem, which neither the FDIC model of Senator Dodd’s bill nor any other system of government support of risk-taking can escape.
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