Commentary

Talking Down the Banking System and the FDIC

By Vern McKinley
This article appeared in Cato.org on October 17, 2008.

At a recent public panel on the financial crisis a former general counsel of the FDIC bluntly characterized the ongoing coordinated efforts between the Federal Reserve Board, Treasury Department and the FDIC as a game of “whack a mole.” These agencies move to resolve the troubles of one financial institution and then another, and then seek first one new power to address the crisis and then another. One result of these efforts, largely driven by Secretary Paulson and Chairman Bernanke, has been to increase anxiety regarding the banking system - and make the FDIC’s job more difficult.

In June, at an earlier stage in this financial crisis, Senator Schumer of New York disclosed a letter discussing the deteriorating condition of a single financial institution, IndyMac Bancorp. The institution’s supervisor, the Office of Thrift Supervision (OTS), criticized the disclosure even though the contents of his letter were accurate. Jonathan Reich, head of the OTS, said at the time: “When a member of the United States Senate makes such a statement, it frightens depositors.” According to OTS, the disclosure precipitated a run on the bank. IndyMac’s subsequent closure will cost the FDIC billions to resolve, eating into its insurance fund for depositors.

As the financial crisis has deepened the past few weeks, Secretary Paulson and Chairman Bernanke have been similarly talking down the condition of the entire banking system. Just as in the case of Senator Schumer, when the Treasury Secretary and Chairman of the Federal Reserve Board make such statements about the banking system, it frightens depositors.

Ironically, a primary source for depositor fears has been their effort to acquire a number of what they have called “tools” to address the crisis, including the power to make up to $700 billion of asset purchases. The tools that Paulson and Bernanke have sought have had one characteristic in common: a lack of confidence in markets to resolve the imbalances caused by government policy in the financial markets. In overpromising the soothing effects of one tool, Paulson and Bernanke have then moved on to securing the next tool.

Another tool that was part of the initial bailout legislation was the temporary increase in FDIC insurance coverage from $100,000 to $250,000 through the end of 2009. The clear implication of this move was that many banks will fail in the next year, and the increase is needed to avoid a run on banks.

The precise issue of the coverage limit was deliberated just a few years ago during more tranquil times as part of the FDIC Reform Act of 2005. According to a Congressional Budget Office study at the time, over 98 percent of all accounts were under the $100,000 limit. The remaining depositors above $100,000 hold greater than two percent of total deposits, but they can spread their risk by using market-based products. Instead, the additional liability for increased coverage has now been foisted upon the FDIC.

An additional tool in the bailout legislation allowed the FDIC to temporarily borrow from the Treasury without limit through the end of 2009. Again the clear implication of this move is that the FDIC may soon be illiquid and will need to borrow to bolster its liquidity. This seems inconsistent with the FDIC’s most recent financial statements issued a month ago that noted a mere $11 billion in probable losses for anticipated failures of insured institutions over the next year. Half of these losses were related to IndyMac which was taken over in July.

The Treasury’s latest tool is to inject capital into the banks, the implication of which is that banks are undercapitalized. The FDIC’s last detailed public pronouncement on the capital position of the banking industry was that “98.4 percent of all institutions (accounting for 99.4 percent of total industry assets) met or exceeded the highest regulatory capital requirements.” If the banks do not want to lend when they have their own capital, why would injecting of public capital change that situation? Other potential tools on the horizon include increasing the deposit coverage limit again, this time to an unlimited amount and also guaranteeing lending between banks.

The big lesson here is that making major legislative changes in times of crisis leads to bad policy (recent examples in the financial sector are the Patriot Act and Sarbanes-Oxley). These “tools” are a euphemism for extraordinary powers that would not be considered in a calm market. They are largely preemptive, and aimed at avoiding bank failures.

The lesson learned during the banking crisis of the 1980s and 1990s when thousands of institutions failed and were taken over by the RTC and FDIC was not to talk down the condition of the banking system - a lesson that seems forgotten.

Vern McKinley worked at the RTC and its Oversight Board from 1990 to 1995 and the FDIC in Texas during the banking crisis of the 1980s. He currently advises central banks and deposit insurers worldwide on their operations.