Viewpoints : Should We Reform Deposit Insurance?

S ince the run on the banks that helped usher in the Great Depression, federal deposit insurance has been a cornerstone of our economy, comforting savers with the knowledge that no matter what happens, their insured money is safe in U.S. banks.

But now, the call to reform deposit insurance is rising. By reducing market discipline in savings and loans, deposit insurance has been a substantial contributor to the nation’s massive thrift crisis, critics say. Last year’s thrift bailout bill required the Treasury Department to study deposit insurance reform and make recommendations to Congress; the Treasury’s comment period ended Friday.

For a debate on deposit insurance reform, free - lance journalist Sharon Bernstein interviewed two former California superintendents of banks. One, Carl Schmitt, is chairman and chief executive of University National Bank & Trust in Palo Alto and head of the California Bankers Assn.’s deposit reform committee. The other, Howard Gould, is managing director of the Secura Group, a bank and thrift consulting firm. Also participating in the debate was economist John Hekman, vice president of the Claremont Economics Institute.

* Is reform really necessary?

Hekman: We need to reform the system so that managers of banks and savings and loans see that they will bear responsibility for risks they take in their investments. Deposit insurance, in effect, allows owners of a financial institution to risk its deposits in investments; if the investments go bad, rather than the owners bearing responsibility, the FDIC will pay off the deposits.

Before the 1980s, we had much tighter restrictions on investments that institutions could make. The financial reforms of 1980 and 1982 removed those restrictions but continued to allow protection for the deposits used to finance the investments.

Schmitt: You have insurance to instill confidence because it’s the confidence of the public that keeps people from creating a run. At the same time, you must make sure the bank doesn’t abuse the insurance. You could say that Congress (created a climate for abuse) by setting up a very poor, if not ridiculous, set of regulatory laws when they deregulated the savings and loans and basically opened the door to the kinds of investments S&Ls; could make.

There is also a second set of abuses. The government has developed a concept of “too big to fail.” Any institution over $10 billion in size was considered too important to close, and they were allowed to continue to operate (even past the point of insolvency).

That was happening at the same time that the regulatory system governing savings and loans was purposely under-funded by Congress and the Administration, and savings and loans were forced to continue in operation past the point of insolvency. As a result of that, you could operate an insolvent savings and loan without fear of closure. Operators, therefore, could use the $100,000 insurance feature to attract investors at very high interest rates, (saying in essence), “Well, we lost on that bet, now let’s go over to the craps table.”

* What are some of the proposed reforms?

Gould: You have suggestions that would drastically alter or replace our current system of deposits. One example is privatization, where you try to create a new system of insurance that is more private than it is governmental. That would have (serious) impact on everybody and would take government out of supporting the banks.

Another is what’s called a “narrow bank” proposal. That says if you’re going to take deposits and the government is going to insure them, then we’re going to make sure you only use those deposits in very safe activities.

Yet another category of proposals basically target the current insurance system. These include the concept of co-insurance, with depositors absorbing some of the loss (when institutions fail). Some proponents of this say we should roll back the $100,000. Another proposal is that even though we have insurance, if your bank fails, you will take a 5% to 10% loss, or “haircut.” Another proposal would be for uninsured deposits to take some haircut.

* If there is to be reform, what would be best?

Hekman: The move to $100,000 insurance was a mistake and also the moves during the 1980s to effectively insure all depositors regardless of size (by paying uninsured deposits when institutions failed) was a mistake as well. I would move, instead, to privatize the insurance, eliminate government insurance.

Schmitt: Reducing the insurance is inappropriate. I would argue, and I think most would argue, that consumers need a level of insurance that represents their general usage of the payment system. The $100,000 limit is something we’ve had since about 1980. I think if you were to take 1980 dollars and convert those into 1990 dollars, you’ll find we’re not talking about $100,000, we’re talking about a lot less. And considering the amount of money that is standard operating procedure for a lot of the economy, that $100,000 is not too low.

What is necessary is removing the “too big to fail” policy and replacing that with a policy that would see some market discipline--i.e., some haircuts taking place--and couple that with a new liquidation system for insolvent institutions.

On average, when you finally get through the liquidation process of a bank, about 90% of the uninsured deposits are paid. This is just from liquidation of the assets. What you do (to hurry up the process) is use a concept called a bridge bank. Close the bank one day and eliminate the bad assets. Put the (solvent) assets in a bridge bank. The uninsured depositors and the creditors take a haircut or a discount equal to what is the average liquidation discount that the Federal Deposit Insurance Corp. has had over the past five years.

You have the bank opened the next day and the uninsured depositor has 90% of his deposit available immediately.

* Deposit insurance has been held up as a reason that we will never see a repeat of 1929. How can you suggest doing away with it?

Hekman: If it was left to the private market, you’d have a choice of insured or uninsured accounts. Depositors get a lower return if it’s insured, and a higher return if they get an uninsured account. That’s the way it should be. I don’t think this would be a burden to be thrust on the average American consumer.

Schmitt: If you eliminate insurance altogether, the purist would argue it would drive the depositor back to making his choice of bank based upon a financial analysis of the bank. The only problem with that is that the average consumer out there has no basis to make that kind of decision. It is a very complicated business.

Hekman: (Deposit insurance) was very important in the 1930s and at least until the 1970s, but we have diversified a great deal now in terms of where people put their money. So with the rise of money market funds, insurance annuities and so forth, it’s not like the average person has all his money in the corner S&L; anymore. And I don’t think they need to.

Schmitt: It’s intellectually very sound to want to do away with insurance. However, you have a society that has come to take insurance as a fundamental piece of the culture. This country has done it with insurance while countries in Europe have done it quite differently to get to the same place, where if you have a failure, the other banks have to bail it out. That’s fine if you have a country with five banks or 25 banks. But we have 14,000.

You could also say, “Gee, if we don’t have insurance, it’ll make every depositor part of the risk and they will make their own decisions.” That’s (expletive). That is exactly what got us into trouble on the S&Ls.; The fact is that you’re dealing with a population of people that can’t make those distinctions. There’s no country in the world that has put that burden on its people.

* What is the most likely outcome of the argument in Congress?

Hekman: Insurance won’t be reduced. They will come up with more regulations. In essence, they will reinstitute restrictions on investment powers of institutions rather than changing insurance. It’s just like changing Social Security.

Schmitt: The American Bankers Assn. proposal is logical, and I pray that Congress will have the sense not to muck it up. (The ABA plan calls for maintaining the $100,000 level of coverage, eliminating the “too big to fail” doctrine and making uninsured depositors suffer some losses of a failed bank.) Unfortunately, Congress is fairly well known for implementing the concept of too many cooks spoiling the broth.