With Bank Failures, the FDIC Is the Problem

Last week, the Senate Banking Committee held a hearing about the lessons learned from the financial crisis regarding community banks. More than 400 U.S. banks-most of them small-failed from January 2008 to December 2011. As we seek to understand those failures, one question worth asking is whether the existing deposit insurance scheme could be reworked to make future failures less likely and less costly.

Deposit insurance, although intended to enhance financial stability, makes bank failures more likely because it discourages monitoring by people who would otherwise watch banks closely. A bank that is carefully watched by people with money at stake is more likely to be well-capitalized and less likely to engage in behavior that could lead to its failure. Nevertheless, Congress, after much heated debate, established federal deposit insurance in 1933, and it came to be viewed as a way to protect small depositors from losses and thus prevent them from running on their banks in times of crisis.

Since the inception of federal deposit insurance, there has always been an upper limit on the amount covered, which is currently capped at $250,000. The thinking is that folks with more than that limit don't need full coverage and, in fact, will be valuable bank monitors if they know that some of their money is not covered.

As with any regulatory limit, there is a way around the deposit insurance limit: brokered deposits. Deposit brokers funnel money to banks from large depositors all over the nation. Depositors have seamless access to Federal Deposit Insurance Corporation backing for deposits without regard for the FDIC's limit and without having to go through the hassle of directly opening and maintaining accounts at multiple banks. These well-heeled depositors don't have to pay attention to the health of any of the banks that are holding their money, because it's all FDIC-insured. So much for relying on them to help monitor banks.

Brokered deposits offer banks access to funds without doing the hard work of developing and maintaining customer relationships. Particularly if banks offer a higher-than-market interest rate, the money will come flowing in from all over the country. FDIC rules restrict the ability of banks to take brokered deposits and the interest they can pay.

Despite these restrictions, there has been a pattern of greater reliance on brokered deposits before a bank fails and greater losses to the FDIC from failed banks that are heavily reliant on brokered deposits. The Government Accountability Office explained at last week's Senate hearing that its "analysis showed that small failed banks in the 10 states [with the most bank failures] had often pursued aggressive growth strategies using nontraditional and riskier funding sources such as brokered deposits."

Similarly, the FDIC, in a Dodd-Frank study about brokered deposits, found that "on average, the use of brokered deposits is associated with a higher probability of bank failure and higher insurance fund losses should failure occur." The FDIC attributes the increase in losses to two factors: First, the more a bank relies on brokered deposits instead of equity capital, the greater the FDIC's losses. Second, when the FDIC sells a failed bank, purchasers will pay for the bank's core deposits, but not for its easy-come-easy-go brokered deposits.

At a minimum, rapidly increasing reliance on brokered deposits appears to be a red flag. A recent GAO report, for example, "found that for small failed banks, the average percent of total deposits that were brokered deposits increased from 3 percent in December 2001 to 20 percent in December 2008, and for medium-size failed banks, from 3 percent to 28 percent. For small and medium-size banks that did not fail, the level of brokered deposits was considerably lower, increasing from 2 percent to 6 percent and from 4 to 13 percent, respectively, over the same time period."

In 1984, the FDIC adopted a rule to make brokered deposits ineligible for deposit insurance. The FDIC reasoned that deposit insurance was never "intended to facilitate shopping by investors for the highest yields in national money markets irrespective of the credit-worthiness of the borrowing institutions." That rule was thrown out in court because it did not comport with the statutory deposit insurance mandate.

Now that we have more evidence regarding brokered deposits, we ought to rethink the propriety of insuring them. In a paper published this week by the Mercatus Center, David Howden recommends doing just that. As he points out, as long as brokered deposits have FDIC coverage, depositors will not take responsibility for their investment decisions, but will happily enjoy high returns without bearing the associated losses. And the brokers who place their funds will also be able to continue avoiding responsibility for assessing risk of the banks to which they entrust depositors' funds. Howden explains, that "insuring brokered deposits removes market discipline and increases instability at the taxpayers' expense." One clear lesson from the last crisis is that taxpayers have already borne too high a price for too little market discipline.