In “It’s a Wonderful Life,” George Bailey finds himself trying to stop a run on his Building and Loan. Fortunately, the money George was about to spend on his honeymoon provided enough confidence to his depositors that the Building and Loan was saved. These days, instead of experiencing a run, a failing bank might simply play host to the Federal Deposit Insurance Corp. over a weekend and reopen as the branch of another bank.
With a government guaranty that their deposits are safe, depositors have no financial incentive to concern themselves with their bank’s asset quality or lending practices.
Quite the contrary, after the financial crisis, we have seen demands for banks to loosen their credit standards and make more loans. Wasn’t it too many bad loans that got us in this problem in the first place?
Think back to an age before the FDIC. The bank or banker you think of most likely projects an air of conservatism. Why? Because conservative lending practices attracted a low-cost funding source: deposits.
Now consider today’s banks. Far from promoting conservative lending standards, banks have learned convenience features are what draw depositors. And the interest rates banks pay on their deposits are more a function of the convenience they offer than their risk profile.
So, with the same access to low-cost, government-insured deposits, the risky bank will thrive, while the more conservative bank stagnates.
The unintended consequence of this arrangement is that loans are made that never should have seen the light of day. This leads to credit bubbles and weakens our entire financial system.
Now proponents of government-insured deposits will point to the fact that we have regulators that monitor the safety and soundness of each bank’s lending practices. That’s true, and in the long run, they’ll catch on to the risky bank’s practices. But by then it’s too late. The bad loans have been made, asset prices run up, and borrowers are stuck trying to pay back loans they simply can’t repay.
Proponents will also argue it is difficult for your average consumer to keep tabs on his or her bank’s risk profile. They’re right. It is difficult, and not everyone has the time or expertise to perform the due diligence.
But not everyone has to. Sophisticated depositors will do their homework and others will benefit from their knowledge. Risky banks will be forced to pay higher interest rates on their deposits, thereby signaling to the public the elevated risk level.
The FDIC does charge higher insurance premiums, or assessments, to riskier banks, but its method for doing so is wholly inadequate. According to the FDIC’s Quarterly Banking Profile (Q2 ’11), 96 percent of all deposits were held in financial institutions in the two lowest-risk categories, where the differential in premium assessments was just 36 basis points.
Also note the conflict the regulators face: By downgrading a risky institution, they effectively increase that institution’s costs, thereby increasing the likelihood the FDIC will have to step in.
Instead of distorting market-based incentives in the financial industry, the FDIC should focus its efforts on creating a more transparent marketplace. For example, why not make public a bank’s ratio of substandard assets to capital?
Increased transparency would help depositors find a safe place for their savings, while also providing a check against reckless lending.
As Congress considers further extensions and increases to FDIC insurance limits, we, as a society, must take into account the unintended consequences. George Bailey sacrificed his honeymoon to provide peace of mind to his depositors.
We created the FDIC to provide peace of mind to today’s depositors. But what are we sacrificing in the process?
Erik Hegg is a business banker in the Twin Cities of Minneapolis/St. Paul.
