Banking on markets - call for a market-driven insurance system

Reason, May, 1994 by Cornelius Chapman

After the S&L crisis, deposit insurance gets new scrutiny.

THE FINAL BILL FOR THE S&L CRISIS is being tallied up, and like the bar tab for a drunken night on the town, it is simultaneously sobering and stomach-churning: at least $200 billion in government funds to pay depositors' claims against the Federal Deposit Insurance Corporation and the now-defunct Federal Savings and Loan Insurance Corporation. And on top of that already staggering figure are less obvious costs--such as additional interest payments on the national debt, an overbuilt real-estate market financed by high-risk loans, and losses of personal net worth for people who bought homes shortly before the bubble burst--that will continue to act as a drag on the national economy for some time to come.

Now that the biggest banking crisis since the Great Depression is over, the question in some people's minds is how to reform the system of federal deposit insurance that grew out of the first major banking debacle of this century and was a contributing cause of the second. "The excesses of the 1980s would not have happened without the federal deposit insurance system," says University of Chicago law professor Geoffrey Miller. Federal deposit insurance, he argues, encourages the very behavior--risky lending--that it insures against, just as federal flood insurance encourages people to live in areas that are prone to flooding.

When depositors have recourse to "free" government insurance, they have no incentive to monitor the prudence of their financial institutions, because they cannot lose their money. And if banks are certain that the government will pay off depositors in the event of a failure, lenders have less reason to avoid high-risk ventures (with potentially higher investment returns). In effect, both depositors and bankers are playing an investment game with other people's--the taxpayers'--money.

THE FISCAL IRRESPONSIBILITY INHERENT in federal deposit insurance prompted Rep. Thomas Petri (R-Wis.) to introduce the Deposit Insurance Reform, Regulatory Modernization, and Taxpayer Protection Act (H.R. 3570) late last year. The bill, which has five co-sponsors, would do away with the FDIC's insurance functions, replacing them instead with "cross-guarantee" contracts by which other banks, insurance companies, pension funds, and anyone else who could satisfy certain tests of financial strength would back bank deposits.

Petri's bill would effectively privatize both deposit insurance and bank regulation, since the federal government's role would be reduced to making certain that a cross-guarantee contract was in place for every bank. Syndicates of private guarantors would decide on the safety and soundness requirements to be imposed on each bank whose deposits they guaranteed, and they would price their services according to the varying levels of risk they chose to undertake. Individual banks could choose from a variety of insurance policies based on price and flexibility. Petri argues that would reduce the possibility of future "credit crunches," since no single insurer would be in a position to dictate what risks were acceptable for all banks across the entire country. But since private investors, unlike the federal government, do not have an effectively limitless supply of money, they have a vested interest in regulating the banks they back.

To avoid disrupting markets during the transition from public to private insurance, the plan would not go into effect until either banks with at least $500 billion in total assets signed on or the expiration of an 18-month period following the passage of the bill, whichever came first. The bill is currently being considered by subcommittees of the Ways and Means, Judiciary, and Banking committees.

"Mispriced federal deposit insurance contributed to a series of asset deflations that caused bank insolvency losses not seen since the Great Depression," says Petri. Until recently, the FDIC failed to use risk-based insurance premiums, argues Petri, enabling banks that were active lenders to "boom" sectors of the economy such as oil and real estate to attract deposits long after warning signs of coming "busts" would have otherwise scared off depositors. Even after the S&L wake-up call, the FDIC has been slow to implement a congressional mandate to do what any non-governmental primary insurer does as a matter of course: privately reinsure its liability to spread its risk.

A market-driven insurance system would not only protect taxpayers from having to bail out failed banks, says Burt Ely, the Virginia-based banking consultant who helped Petri devise his plan, it would also allow banks to be more responsive to local economies and their needs. As it stands, the nationwide regulatory laxness that precipitated the S&L crisis has merely been replaced with a nationwide regulatory strictness. The result is an excessively tight credit crunch, with bank loans falling 2 percent since 1991, despite increased credit requests. "A market will price riskier loans at higher rates," says Ely. "One-size-fits-all regulation of banks resulted in enormous losses that could have been avoided."