The mess that is deposit insurance

August 16, 2010

There are three reasons to have deposit insurance. The first reason is systemic: it prevents bank runs. There’s no rush to pull your money out of the bank if you know that the government is guaranteeing your deposits. As a result, the entire banking system becomes much more stable and secure.

The second reason is one of simple fairness: depositors shouldn’t be expected to do due diligence on the banks where they deposit their money. And when a bank fails, those depositors shouldn’t lose their money.

The last reason is by far the least noble of the three, but even the FDIC admits that it comes into play when the deposit insurance limit is raised: every time that happens, depositors increase the amount of money they have in bank CDs. So if the government wants to help shore up a rickety banking system, one cheap way of doing so is to increase the FDIC insurance limit. Suddenly, the banks will see an inflow of relatively cheap funds, and will seem to be in much better shape.

So what are the reasons to have a cap on deposit insurance? Why not make it millions of dollars?

One reason is that bank CDs always yield more than Treasury notes, while carrying exactly the same government guarantee. Without a cap on insured deposits, investors would desert the Treasury market in droves, getting the same safety and much higher yields from their local bank.

The second reason is moral hazard. Waving an FDIC guarantee makes it almost too easy for banks to attract deposits. And when every bank has an FDIC guarantee, they’re forced to compete by offering higher and higher interest rates — which in turn forces them to take greater and greater risks with their lending. If the guarantee is set too high, the resulting increased risk in the banking system will more than offset the decreased risk from bank runs.

All of which brings me to Nassim Taleb, who recounts a tale from early 2009:

I was interrupted by Alan Blinder, a former Vice Chairman of the Federal Reserve Bank of the United States, who tried to sell me a peculiar investment product. It allowed the high net-worth investor to go around the regulations limiting deposit insurance (at the time, $100,000) and benefit from coverage for near unlimited amounts. The investor would deposit funds in any amount and Prof. Blinder’s company would break it up in smaller accounts and invest in banks, thus escaping the limit; it would look like a single account but would be insured in full. In other words, it would allow the super-rich to scam taxpayers by getting free government sponsored insurance. Yes, scam taxpayers. Legally. With the help of former civil servants who have an insider edge.

I blurted out: “isn’t this unethical?” I was told in response, “We have plenty of former regulators on the staff,” implying that what was legal was ethical.

The product in question is CDARS, and Blinder is a founder of the company which invented them. When Blinder wrote an op-ed complaining about an attempt to broaden deposit insurance, I was underwhelmed, writing that “Blinder has a massive conflict: he’s the vice-chairman of the company which runs CDARS, a financial instrument designed solely to get around FDIC deposit limits.” Without deposit limits, of course, CDARS become moot, and Blinder loses a large chunk of income.

I first wrote about CDARS back in 2003, shortly after they were introduced, in a Euromoney article which is behind a paywall. I wrote then that Promontory, Blinder’s company, was “doing a job that almost seems as if it should be performed by the Federal Reserve, or some other branch of the government”. But it wasn’t until Bloomberg’s David Evans came along in September 2008 that it became clear exactly what the problem is here:

Promontory charges banks more in fees, about $12.50 per a $10,000 one-year CD to get access to federally insured funds, than the FDIC itself charges in insurance premiums, typically $5-$7 per $10,000 deposited.

Essentially, Promontory is selling an insurance product, and collecting insurance premiums, even though it’s the government, and not Promontory itself, which is providing the insurance. That’s why Taleb calls the whole thing a scam.

In October 2008, the FDIC temporarily raised the insured limit on deposits to $250,000 from $100,000, making it very clear that the limit would come back down to $100,000 at the end of 2009. But in May 2009, the FDIC extended the “temporary” period all the way through the end of 2013. And in July of this year, the inevitable happened, and the $250,000 limit was made permanent.

The increase in the FDIC limit does increase the amount of moral hazard in the system; it also increases the amount of protection that depositors have. It does not meaningfully reduce the chance of bank runs, which is the main reason for FDIC insurance to exist in the first place. But it does help banks to hold onto deposits which would otherwise depart for money-market funds and the like.

While banks were getting all of this lovely support from the government, money-market funds were spending a whopping $12.1 billion to prevent their funds from slipping below the $1 mark, and more than 200 of them would have done so without injections of capital from their parents.

The whole thing is an ad hoc legal and regulatory mess, cobbled together largely on the basis of who has the best lobbyists: one minute it’s Promontory, next minute it’s the banks, and almost never does it seem to be the money-market funds. If you were starting a system from scratch it would never look like this, as can be proven by the fact that products like CDARS don’t exist in other countries, and also by the fact that CDARS don’t have any competition.

The FDIC itself is reasonably serious, these days, about charging realistic premiums for its services. (Premiums were unforgivably set at zero between 1996 and 2006, which isn’t the fault of the FDIC but of Congress.) But with the Dodd-Frank bill now signed into law, root-and-branch reform to the deposit-insurance landscape has become a political impossibility — which is fine by Congress, which loves to be able to meddle in such things when their local bankers ask them nicely.

And when the entire system is as politicized as this, it’s hardly surprising that the likes of Alan Blinder will embark on highly-lucrative regulatory arbitrage. He should probably just avoid trying to sell those schemes to Nassim Taleb in future.


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