The Outlook for the FDIC’s Deposit Insurance Fund

On Sept. 29, the FDIC proposed that banks pump cash into the Deposit Insurance Fund, or DIF, by prepaying $45 billion of deposit insurance premiums. While this prepayment will address the FDIC’s short-term cash-flow needs, it has heightened confusion about the DIF’s financial outlook.

It is important to understand that the FDIC is not an insurance company. Instead, the FDIC merely operates a government guarantee program funded entirely by banks. The DIF balance is merely an accounting as to whether the banking industry is ahead or behind in paying for the FDIC’s operating expenses and the losses it incurs in protecting depositors in failed banks. The DIF balance sheet below reflects that accounting and is key to understanding the fund’s outlook.

The DIF’s reserve ratio (the DIF balance divided by estimated insured deposits) measures the extent to which the banking industry has prepaid for future FDIC expenses and losses. There is no actuarial rationale for the 1.15% target for the reserve ratio that Congress has establishedu2013it simply is an arbitrary percentage that has evolved over time. At June 30, 2009, the reserve ratio was .22% ($10.368 billion divided by estimated insured deposits of $4.82 trillion). The FDIC has warned that the ratio may be negative as of Sept. 30 of this year, which has raised concerns that the FDIC will not be able to protect depositors in failed banks. Those concerns are vastly overblown, for several reasons.

First, the DIF’s contingent liability for future failuresu2013$31.968 billion on June 30, as shown in the DIF balance sheetu2013must be added to the DIF fund balance of $10.368 billion to measure the DIF’s total loss-absorbing capacity on June 30 of $42.336 billion. That is, on June 30, the banking industry had effectively paid into the U.S. Treasury $42.336 billion more than the FDIC had spent to that date protecting depositors in failed banks. The contingent liability represents the FDIC’s estimate, as of June 30, as to the amount of loss it will incur in failed banks over the following 12 months.

Second, the banking industry is paying substantial premiums into the DIFu2013$11.71 billion during the first half of 2009u2013which, over time, pays the FDIC’s bills. Depending on the extent of future special assessments, banks will pay $12 billion to $15 billion annually in deposit insurance premiums for the foreseeable future.

Those premiums, plus the $42.3 billion in fund balance and contingent liability at June 30, should more than cover the $89 billion in bank-failure losses the FDIC anticipates from June 30, 2009 to the end of 2013. That is, by the end of 2013, the banking industry will still have paid more into the U.S. Treasury than the FDIC will have spent.

Third, much of the agonizing about the DIF’s finances reflects a concern that the FDIC will run out of cash. That is a legitimate concern as the FDIC is carrying substantial receivables from failed-bank resolutions. However, those receivables will decline, and cash will be returned to the DIF, as failed-bank assets are liquidated.

The DIF could finance these receivables by temporarily borrowing from the U.S. Treasury under its $100 billion line of credit. Unfortunately, FDIC Chairman Sheila Bair has so stigmatized borrowing from the Treasury that the FDIC has instead proposed that banks prepay their next three years of premiums, bringing $45 billion into the FDIC. Banks would then amortize that prepayment into their operating expenses over the next three years.

By 2013, the FDIC’s losses and cash-flow needs should subside substantially. Unless the cost of resolving failed banks exceeds the FDIC’s most recent estimate, the banking industry, and therefore bank depositors, will pay the entire cost of these failures, thus protecting taxpayers from any loss. Thereafter, premium assessments will rebuild the DIF balance; that is, the banking industry will begin prepaying the cost of resolving the next banking crisis.

Guest columnist Bert Ely is the principal of Ely & Company, Inc. He is an expert on deposit insurance matters, monetary policy, and the regulation of banking and financial services.