Is the Law of Unintended Consequences at Work at the FDIC?

The Federal Deposit Insurance Corporation (FDIC) temporarily increased the limit on bank checking and savings deposits to $250,000 per qualified account through 2009. The move was made to reassure depositors in the wake of bank failures and panicked withdrawals amid the so-called subprime meltdown. It seems to have worked to mitigate depositor anxiety for now, but can we expect unintended consequences yet to surface from this seemingly helpful hand of government?

The insurance program has worked well enough since instituted during the era of “The Great Depression”; however, failures during 2008 have resulted in a considerable depletion of the fund. To replenish the fund banks willbe to pay considerably higher premiums in 2009. A sound bank, like Blue Ridge Bank, with assets of $500,000,000 and an annual assessment history of $40,000 to 50,000, will pay 13 times that amount.

Depositors reacted predictably to the credit crisis. Fearing the unknown, safety of principal became paramount. Consequently dollars moved from uninsured accounts, e.g., mutual fund money markets to insured ones, and, encouraged by yields 2% to 3% above Treasuries of similar maturity, total deposits have grown. But so has the fund’s liability. The FDIC lists 117 banks with troubled assets, all holding $250,000 accounts.

The FDIC’s move has provided depositors increased protection, but banks whose higher premiums will make possible the safety of those deposits are not so assured. Likewise, the position of the insurance fund has become more tenuous, since future failures are likely to require larger reimbursements. Time will tell whether the FDIC moves will help or hurt and whether the temporary solution will become permanent.

FDIC’s revised premium calculations further differentiate risk among banks and assess riskier ones a higher premium. While reasonable on the face, the rules do not seem to contemplate their effect on creating risky banks from sound ones during a recession. Higher premiums will create pressure banks’ earnings, one of the factors used to determine its risk rating.

Earnings risk typically increases during recessions as loan customers struggle to make payments and banks reserve for losses from earnings. But with more dollars paid for premiums fewer are available to reserve for troubled credits. The combination can only serve to increase pressure on bank earnings, but more immediately, on liquidity. That rates for demand accounts exceed those for Treasuries is more about liquidity needs than underwriting loans. Is the rate dislocation the proverbial canary in the cage?

Has the FDIC, perhaps unwittingly, created a negative feedback loop? By imposing higher premiums, earnings are reduced. Lower earnings increase a bank’s risk rating, leading to higher premiums and producing collateral effects such as reduced liquidity, also a risk measure. In the meantime banks are being tossed a concrete life ring by the Treasury Department with more stipulations than a prenuptial agreement.

Bank failures do not necessarily have a dollar-for-dollar effect on the insurance fund. Sound banks may acquire the deposits of troubled banks, thereby reducing the net charge to the fund. The Troubled Asset Relief Plan (TARP) will provide dollars that might be used for consolidation. This, of course, assumes the economy will not worsen, in which case borrowed funds would likely be used to maintain capital rather than for acquisitions. In any event, should the rate of bank failure exceed acquisition, magnified deposit liability might eliminate even a sound bank’s ability to meet FDIC premium requirements.

Increasing limits for deposits was overdue. Increasing limits during a time of panic was perhaps necessary. Keeping the fund solvent is essential to the banking system. While the FDIC’s priority is insuring deposits not banks, the banks that hold them are necessary to the recovery. FDIC is forecasting additional failures in 2009. But are the agency’s actions contributing to the extent and number of failures?

While not a staunch supporter for TARP (or is it TRAP?), I believe some of the money could be applied to the insurance fund in lieu of higher premiums at least until the economy improves. It would leverage banks without reducing earnings and liquidity, thereby making it easier for them to resume the pace of lending. A repayment plan over time would make the premium manageable, not just another form of risk.

“If you experience severe nausea, night sweats, or loss of appetite see your doctor,” is a familiar warning we hear repeated in advertisements. Side effects are indicators of unintended consequences of drug action. Maybe government actions should come with similar warning labels.

More simply put is what I call the teeter-totter principle. We all learned this principal as children; sitting down on one side of a teeter-totter cannot be done without raising the other. So too, in banking, both the government and its agencies should be mindful that pulling the levers marked “expedience” is not possible without launching unintended consequences. Take two aspirins and call your doctor.

Paul M. Thomson

President, Truman Heartland Community Foundation; Director, Blue Ridge Bank and Trust, Independence, Missouri

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