The FDIC's Cupboard Is Very Bare

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Once again, Washington's so-called deposit insurance program is faced with the possibility of running out of cash.

Bank failures have multiplied as a result of mounting loan losses. Thus far in 2009, the Federal Deposit Insurance Corporation has been obliged to take over 81 institutions. Reimbursing depositors at the busted banks has reduced the FDIC's insurance fund from a March 2008 peak of $52.8 billion to just $10.4 billion. That compares with combined assets of $299.8 billion at the 416 banks that the FDIC currently classifies as leading candidates to go broke.

As Chairman Sheila Bair emphasizes, the FDIC is not facing failure bankruptcy itself. It is just a little short of cash, much as it was during the savings and loan crisis two decades ago. The problem is that the depositors must be reimbursed right away, but it takes some time to generate funds from the sale of the failed bank.

One strategy that the FDIC is considering to fill the gap is to hit the banks under its coverage with a special assessment. Now, that might strike you as an odd way for an insurance company to operate. Suppose you paid your auto insurance premium and your carrier later experienced higher-than-expected claims. You would be pretty upset if the insurer demanded you pay an extra premium to make up for its underwriting error.

The explanation of the Federal Deposit Insurance Corporation's peculiar behavior is that it is not in fact an insurance company in any real sense. That is made clear by Time columnist Justin Fox's cheery assurance that depositors need not worry one bit about losing their savings. He points out that the FDIC can borrow up to $500 billion from the U.S. Treasury, subject only to the approval of the Treasury Secretary and the Federal Reserve Board. Beyond that, Congress has stated in the past that FDIC-insured deposits are supported by Uncle Sam's full faith and credit.

In short, the FDIC ultimately has no need to operate as bona fide insurance companies do, charging premiums high enough to cover expected claims. Secure in the knowledge that it can tap taxpayers for its losses without limit, the FDIC naturally takes the path of least resistance, caving in to political pressure against running an actuarially sound business. That would mean requiring banks to meet a rigorous credit standard to qualify for coverage. It would necessitate charging high-risk banks steeply higher premiums than safer banks. Armies of bank lobbyists make sure our elected officials fend off any such "discriminatory" practices.

True, Chairman Bair says the FDIC is currently planning to charge significantly higher premiums to banks that make risky loans. Oddly enough, that very same reform supposedly was instituted by the FDIC Improvement Act of 1991, enacted in the wake of the S&L debacle. No doubt, the next time (and there surely will be a next time) the FDIC finds itself in a tight spot, it will once again announce that it has adopted the elementary principle on which every genuine insurance company operates.

The second saddest thing about the FDIC's current troubles is the widespread belief that it represents the most successful social program of all time. In a representative comment, a website named "Government Is Good" cites federal deposit insurance as an example of "public sector programs [that] have actually amassed an admirable record of success in a wide variety of policy areas." The fact is that in the S&L crisis, depositors avoided the loss of their deposits only by virtue of bailing themselves out in their guise as taxpayers. We may witness a similar robbing of Peter to pay Peter before the present financial crisis ends. If that counts as a public sector success, what, one wonders, constitutes a failure?

The saddest thing about the FDIC's current troubles is that a private-sector plan could be devised with the proper incentives to protect depositors while also avoiding the need to go hat in hand to the Treasury every twenty years. We know this because just such a system, known as a clearinghouse, operated in several major cities until being abolished with the establishment of the Federal Reserve System in 1914. Even before that, banks devised statewide associations to back one another up and thereby prevent bank runs. In order to participate, a bank had to remain adequately capitalized and its partners in the venture were strongly motivated to monitor its financial position closely. This arrangement was put to rest by federal legislation of 1863 that established a national banking system.

It is too optimistic to suppose that Congress will conclude any time soon that its 75-year-old experiment with government-sponsored deposit insurance is inherently flawed. Our lawmakers might at least have the decency, though, to remove the misnomer from their ill-conceived scheme. The Federal Deposit Insurance Corporation should be called what it is, namely, window dressing for a taxpayer guarantee of deposits at banks that consider it their right to act irresponsibly at someone else's expense.


Martin Fridson is the author of Unwarranted Intrusions: The Case Against Government Intervention in the Marketplace (John Wiley & Sons). 

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