Synthetic Extended Deposit Insurance – the Critique

Maximizing deposit insurance coverage is a favourite topic with my friends at Financial Webring Forum – see, for example, the thread Multiple RRSP accounts advisable when reach $100k?, and that’s only the first one I found. People go into endless loving detail about how to maximize coverage through use of separate accounts for spouses, joint accounts, trust accounts, multiple institutions … in the States, there’s an outfit called Promontory that handles all that for a fee.

I mentioned Promontory briefly yesterday:

There has been some criticism of a diversification service which allows large deposits to be distributed amongst many banks and be entirely insured:
“When I first saw Promontory, I was amazed that the regulators would let it fly,” says Sherrill Shaffer, a former chief economist at the New York Federal Reserve Bank. “It undermines a lot of the safeguards around the FDIC deposit fund. I’m astounded that the FDIC has not picked up on that and tried to shut down that loophole.”

The loophole Promontory exploits is the FDIC rule that allows an individual to open up federally insured accounts of up to $100,000 at an unlimited number of banks.

Edward Kane, senior fellow of the FDIC’s Center for Financial Research, says CDARS intercepts FDIC premiums.

“It’s portrayed as a public-spirited way to help customers as opposed to a way to game the system,” he says. “They’ve decided there’s a loophole that they’re in charge of.”

… which I confess I don’t understand. The only legitimate criticism I have been able to come up with is that it exploits the minimum and therefore deprives the financial system as a whole of the due diligence that would arise from a large depositor being worried about the soundness of the bank he uses. But this concern is not consistent with the criticism in the article, or with the level of disdain for the process expressed.

However, I have had some discussion with specialists in the field; the concern is that the FDIC is insuring all deposits anyway – the Wachovia deal – and should get paid for it. Infinite deposit insurance! Now there’s a moral hazard issue if ever there was one. Problems at IndyMac & WaMu and the subsequent wipe-out of common shareholders were brought to a head by a run on deposits … it seems to me that infinite deposit insurance will allow banks to ignore the hazards of losing confidence.

So, when you don’t understand something, you ask a question, right? It saves a lot of time. I sent an eMail to Prof. Sherrill Shaffer:

You are quoted in the captioned story at [Bloomberg] as saying ““When I first saw Promontory, I was amazed that the regulators would let it fly. It undermines a lot of the safeguards around the FDIC deposit fund. I’m astounded that the FDIC has not picked up on that and tried to shut down that loophole.”

I regret that I do not understand your criticism. If we can accept that FDIC premia are computed rationally and based on insured deposits, then Promontory is simply engaged in an exchange of value.

The only criticism I have been able to come up with is that when a large depositor’s assets are diversified amongst banks in this manner, the system as a whole is deprived of the due diligence that he might otherwise do if the bulk of the deposit was uninsured. But the Bloomberg story does not bring up this critique.

I would be very grateful if you could help me understand your concern.

Dr. Shaffer was kind enough to respond at length and to grant permission to be quoted.

You are correct that extended deposit insurance coverage (whether statutory or synthesized) does tend to reduce the degree of market discipline exerted by large depositors.

The more market discipline that’s in place, the better it is for everybody … although it should be noted that I am referring to market discipline that is rational. The excesses of irrational (or uninformed) market discipline is what causes perfectly good banks to suffer runs in the first place, which is why the discount window was invented. The Panic of 1907 is the classic example, but there is also the Panic of 1825 and the events following the collapse of Overend and Gurney.

It should be noted, however, that evidence of rational market discipline of banks is a little hard to come by. In the post Banks and Subordinated Debt, I highlighted the Cleveland Fed’s mostly vain attempt to extract useful information from credit spreads. Given that it is institutional investors who will determine these spreads – and FIXED INCOME institutional investors at that, who are well known to be both much smarter and better looking than the equity guys – I suggest that hopes for market discipline exerted by large retail depositors is more of an expression of piety than the foundation of successful regulation.

You are also correct that Promontory would be engaged in a simple exchange of value if the FDIC premia were computed on the basis of insured deposits. However, FDIC premia are instead computed as a fraction of (essentially) total domestic deposits, not merely insured deposits. (The exact assessment base is total deposits, less foreign deposits, less cash & due from depository institutions, less pass-through reserve balances, less a few smaller exclusions – please see pages 2-3 of the attached file.) Under this current system, any means of extending deposit insurance coverage to a larger fraction of total domestic deposits does not directly result in larger premium payments to the FDIC.

I have uploaded the file regarding FDIC assessments.

I hadn’t been aware of that. I am open to correction, but it seems to me that establishing deposit insurance premia based on total deposits rather than insured deposits rather undermines the policy objective of market discipline:

  • The FDIC will be on the moral defensive should it wish to enforce the limit at the expense of uninsured depositors
  • There is no advantage to the insured institution, in terms of premia, to establish a reputation for soundness that will attract uninsured deposits.
  • There is less room than there might otherwise be for institutions to offer higher rates for uninsured deposits, rewarding depositors for the (perceived) additional risk

Rather, the banking industry as a whole is assessed higher premium rates in years when the FDIC’s fund drops below the Designated Reserve Ratio spelled out in federal law. To the extent that Promontory member banks impose larger losses on the FDIC when they fail, non-Promontory banks help pay the tab to the same extent as Promontory banks, and thus cross-subsidize the extra coverage provided to Promontory banks.

So the first problem caused by CDARS is that the FDIC is not compensated for the additional risk ex ante, and any ex post compensation involves an element of cross-subsidization from non-CDARS banks. This is the “unpriced risk” concern.

I agree, all this follows from the fact that premia are charged on uninsured deposits at the same rate as insured ones.

A second problem is that, if our policy makers desired to extend deposit insurance coverage to larger accounts, doing so by statute would avoid the overhead costs (data base costs, marketing costs, administrative and executive costs, etc.) associated with a synthesized coverage such as CDARS. Those overhead costs therefore represent a deadweight loss, paid directly by CDARS banks but ultimately passed on to society. This is the “efficiency concern.”

This is a familiar argument that is seen in virtually everything that can be construed as a “public good” – medicare, toll-roads, transit, you-name-it – not just deposit insurance. One’s views on this question will be heavily influenced by idealogy; there’s no need to go into it in detail here.

There’s not enough information, either! If there was, in fact, a two-tiered deposit system in which the market clearly differentiated between insured and uninsured deposits, then we could start dissecting the data to determine where the line between the two should be drawn. But there ain’t, so we won’t.

A third problem, more philosophical in nature, is that Congress has periodically re-visited the question of whether $100,000 is an appropriate ceiling on FDIC coverage, and thus far has rejected the alternative of raising that cap (although that may change soon). By achieving a much larger cap of $50 million for participating banks, CDARS legally circumvents the expressed intent of Congress. Equivalently, we can view CDARS as extending to all depositors the same protection accorded to depositors in “too-big-to-fail” banks – a protection that Congress has explicitly sought to limit, as in some provisions of the 1991 FDIC Improvement Act. Thus, the effect of CDARS runs contrary to the spirit, though not the letter, of federal law.

On the other hand, one might consider CDARS as being a simple diversification mechanism … like a mutual fund in many ways, although the big difference is that the “diversification” is simply a mechanism to achieve concentration in FDIC’s credit strength. I will suggest that a great deal of this problem would be solved if Congress applied the same limit to premium calculation as it does to insurance coverage.

*********************

There are other cross-currents in the mix. I have briefly mentioned (most recently on May 16) the Fed’s decade-long drive to pay interest on reserves; the idea being that increasing the attractiveness to banks of reservable deposits will assist the Fed to transmit its monetary policy to the broader economy. And we have recently witnessed the bizarre occurance of Treasury writing Credit Default Swaps on MMFs (see September 19) … it’s totally unclear to me what long-term influence that might have, and whether policy will change to require banks to hold capital against branded MMFs.

As far as I know, the CDIC charges premia based on insured deposits only:

Premiums are based on the total amount of insured deposits held by members as of April 30th each year, calculated in accordance with the CDIC Act and its Differential Premiums By-law, which classifies member institutions into one of four premium categories.

Classification is based on a mix of quantitative and qualitative factors. Premium rates in effect for the 2006 premium year, unchanged from 2005, were as follows:
• Category 1—1/72nd of 1% of insured deposits
• Category 2—1/36th of 1% of insured deposits
• Category 3—1/18th of 1% of insured deposits
• Category 4—1/9th of 1% of insured deposits

Note that 2007 “saw 98 percent of its members ranked in the best rated premium categories”. So much for this great-sounding differential premia song-and-dance!

These are strange times and the public demands the right never to lose money on short term investments, particularly the ones that pay higher interest than stinky old T-Bills. But I want to thank Dr. Shaffer again for taking the time to respond in such detail to my eMail.

Update 2008-10-3 Dr. Shaffer has read this post and comments:

Although I haven’t yet begun to dwell on such possibilities, much of the problem would be solved if the FDIC’s premium rate structure could be revised to charge banks in proportion to their insured deposits rather than their total domestic deposits.

A further option could be considered under such a revision: Banks could perhaps be given their choice of what level of coverage to receive (and pay for), whether $100,000 or some larger amount. As long as the pricing was actuarially fair, any such choices would be revenue-neutral to the FDIC on average.

Of course, choosing a larger level of coverage would tend to undermine market discipline, as you corrected noted. But recent events have indicated that the existing market discipline was already inadequate to constrain risk-taking at many institutions, even with the post-1980
$100,000 limit.

The idea of letting the banks themselves decide where to the draw the line is an attractive free-market solution, but I’m not convinced (yet!) that such a move would be in the public interest.

I perceive deposit insurance to serve the purpose of:

  • To aid the economy by letting Mom and Pop know that they are perfectly safe in keeping a cash float at the bank
  • To reduce the risk of self-feeding runs on the banks that might otherwise occur if Mom & Pop decide that their emergency stash is not safe
  • As a public service, so that Mom & Pop don’t have to read and understand a bank’s annual report prior to depositing the weekly paycheque

If everybody was a professional fixed income analyst, there would be no need for deposit insurance at all. And therefore, I say, a variable cut-off (however attractive theoretically) is simply too complicated. Let Mom & Pop know that if they invest their tuppence wisely in the bank it will be safe and sound; and any bank has the same magic number to remember. Simply because of the policy objective to simplify the process.

Incidentally, I think the $100,000 limit is far too high to begin with. Given my views on the proper policy objective, I think that something along the lines of “median household annual income, rounded up to next $10,000, reviewed every five years” is much better. If you have more than that (in cash!) … well, sorry guys, either diversify your banks or buy a money market fund.

Update #2, 2008-10-3: In accordance with legislation passed today, the limit is now $250,000 until Dec. 31, 2009, according to the FDIC.

One Response to “Synthetic Extended Deposit Insurance – the Critique”

  1. […] agree. In fact, as I suggested in Synthetic Extended Deposit Insurance: The Critique, deposit insurance should be keyed to a large fraction of median household income. That will be […]

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