Monday, May 14, 2012

Deposit Insurance Is The Problem

Why do we have federal deposit insurance for banks?  Today's federally guaranteed checking accounts, FDIC guaranteed, have their origin in a 1934 banking law designed to prevent runs on banks.  In practice, FDIC has always paid off all bank creditors, not simply those creditors who qualified legally under FDIC protection.  This is why so many banks are now "too big to fail."

The FDIC exceeded its statutory authority and thwarted the clear design of the 1934 Act.  Now, Dodd-Frank has codified this into a blanket guarantee for all "large" banks.

This creates two problems: 1) the government now thinks it should run all aspects of commercial banking; 2) banks have an incentive to gamble since the government guarantee means they can lose money with impunity yet still get low cost financing.

Every time there is a problem, like the recently revealed $ 2 Billion hit by JP Morgan, there is a call for more government regulation and new laws and restrictions on (all) banking.  Ultimately, this means that commercial banking becomes merely a creature of the state and subject to political whim.  This is what China has and would like to be rid of.

The right answer is to roll back FDIC guarantees to what they were originally intended to be: protection for moderate size checking accounts.  It's supposed to protect the first $ 125,000 of an individual's checking account.  If the federal guarantee were rolled back to that, and if an individual could not have more than a single guaranteed account beneficially, then we wouldn't be concerned about taxpayer exposure, because exposure to this kind of guarantee would be modest.  That's what the framers of the 1934 FDIC Act assumed they were guaranteeing, not the current blanket guarantee that effectively covers all of the creditors of each and every commercial bank in the system.

Bank creditors, other than small depositors, do not need federal guarantees.  There is simply no reason for taxpayers to protect the bondholders of Citigroup or JP Morgan -- none at all.  Such guarantees entice Citigroup and JP Morgan to make bets that they would not make, absent such a blanket federal guarantee and the low financing rates that come with that guarantee.

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