While the topic of the day is health care reform (my proposal, at length, found here), it’s instructive to reflect on the financial crisis, the law of unintended consequences, and examine where even innocuous sounding policy can lead to grievous damage. A number of factors led to the meltdown last fall, but one that few have talked about is the FDIC program itself.
The FDIC originated to prevent bank runs. Before insured deposits, “runs” would destroy banks as a self-fulfilling prophecy. Rumors of bank weakness would lead to withdrawals that, in fact, weakened the bank. The Federal Reserve is supposed to assist in such circumstances by advancing funds to the bank to cover its liquid deposits in the face of illiquid assets (loans). But the FDIC exists to prevent the run from starting. With the full faith and credit of the Federal government backing up deposits, there’s no need for the panic to develop in the first place.
This sounds all well and good, and in preventing bank runs, it has worked as intended. FDIC insurance is engrained in consumers and politicians as a cornerstone of our banking system. I’ve spoken elsewhere in this blog about moral hazard. Remember that moral hazard is the economic concept that people alter their decision-making when they know they’re indemnified against bad decisions.
Let’s understand how FDIC insurance leads to moral hazard in two bankers, Reserved Ralph and Cowboy Chuck. Reserved Ralph is an old school banker, so little found these days, who makes loans only to superior credit quality borrowers. Because these borrowers are so pristine, they have many options where they can borrow, so Ralph must offer them reasonable interest rates. Ralph earns a lower, but safe, interest rate on loans, but cannot pay high interest rates on deposits. Cowboy Chuck likes to live on the wild side, lending to speculative borrowers pursuing projects with little equity and crowded markets. He gets to charge these borrowers high interest rates, in part because these borrowers find few other willing lenders. Chuck may lose some of his bets down the road, but for now, he’s swimming in interest earnings. In fact, he’d like to grow his bank, so he starts offering high rates on CDs, selling them through stockbrokers where he can reach many depositors outside his geographic area.
In a world with no FDIC insurance, depositors might care about the loans made by Ralph and Chuck. In fact, a careful depositor might accurately interpret Ralph’s low interest rates as a sign of safety and Chuck’s high rates as a sign of weakness. While some depositors will still seek Chuck’s higher interest rates, a number will feel safer depositing in Ralph’s bank.
Now let’s add FDIC insurance and see how this changes everybody’s behavior. As a depositor with FDIC insurance, I can choose Chuck’s high interest rates with NO CONCERN FOR SAFETY. All market-based tradeoffs between interest rate and risk have been obliterated by the existence of deposit insurance. In fact, the market forces have been completely turned upside down. Ralph finds himself unable to compete and grow with his safe lending standards and low deposit interest rates. He’s forced to start behaving like Chuck, because consumers are flocking to Chuck’s high interest rates on deposits. Chuck’s sign of weakness is interpreted by consumers as a sign of strength.
This is moral hazard, and it was a strong contributor to the cowboy behavior that led to weak lending standards and weak balance sheets. (Another huge contributor was the lack of regulation on securitized debt issuances, enabling infinite leverage ratios and whose potential returns to investors were more like banker Chuck’s, driving another nail into Ralph’s conservative coffin.) Something as innocuous and popular as deposit insurance in fact had a ticking-time-bomb effect on banker behavior. Higher systemic risk was an unintended, but wholly predictable, consequence.
How can moral hazard be avoided? Surely FDIC insurance does help prevent bank runs, and it’s among the best-run of the regulatory organizations in the oversight infrastructure. We could have the best of both worlds, however, if Chuck were forced to pay true risk-based insurance premiums high enough to place Chuck and Ralph back on a level playing field. If Chuck’s risky loans caused him to pay such high insurance premiums that he couldn’t, as a result, pay sky-high deposit interest rates, then Chuck and Ralph compete fairly for depositors, and a race-to-the-riskiest never ensues.
What matters to consumers and regulators is to have deposit insurance, protecting deposits and preventing bank runs. However, it was an incorrect assumption that this insurance had to be provided by one bureaucratic insurance company, the FDIC. Let’s think about an alternative structure that might replace the single FDIC: 1) have the government charter 6-12 independent insurance companies to offer deposit insurance, 2) have the government establish a standard insurance contract much like the FDIC’s current contract, 3) force each of the chartered insurance companies to offer the exact same insurance contract and force banks to purchase such insurance, 4) make the chartered insurance companies compete BASED ON PRICE to offer such insurance to banks, and make the re-quoting of policies happen once or twice per year, 5) have the government charge each of the chartered insurers a premium for re-insurance, so the ultimate guarantee still rests with the government.
Under such a structure, the 6-12 independent insurers would have tremendous incentive, through the profit motive, to understand deeply the risk factors that were lurking on bank balance sheets, evading government regulators. Those risk factors would have driven Chuck’s rates up, perhaps sky high, or if Chuck’s bank were bad enough, insurance might not even be available (which is, of course, the signal to begin liquidating Chuck’s bank). Chuck’s rates would be set by profit-motivated analysts not constrained to a single “regulatory framework” but based upon in-depth analysis of what lurked under the hood of various bank balance sheets. The FDIC tries to do this, but is hamstrung by its own bureaucratic requirements. (In March of 2008, the FDIC called 99% of banks well capitalized, which may have been technically true, but the other 1% have apparently cost us dearly.) Private analysts are allowed to use intuition or hunches, and can change the way they weight various red flags and risk factors. Government agencies cannot do the same, and would be excoriated politically for trying.
Some will decry that a system like I describe allows the private insurers to earn a profit. This profit is the price we pay to have them working hard, and if we’ve set up the system correctly, they work hard on our behalf. It’s also the payment for having private capital provide for a certain percentage of losses, rather than taxpayers taking the hit at the first experienced loss. It is certainly true that the FDIC doesn’t earn a profit, but that doesn’t make theirs the cost-effective approach. I would expect the FDIC to revert to a re-insurance role, and apply their regulatory oversight and workout assistance when the market clearing price for deposit insurance gets too high for some banks, indicating weakness that the market sees.
Under a solution like I propose, it’s crucial to STANDARDIZE terms of coverage. The system works when market clearing prices indicate differences in underlying risk, not differences based upon bells and whistles that might ordinarily define “private” insurance contracts. When establishing a competitive marketplace, it’s crucial to control all other variables and allow the market to solve for price, just like is done on a commodities or stock exchange. The key is, and always has been, to set up the game so that market forces behave consistent with policy goals rather than contrary to them.
At the end of the day, we’d get what we want—deposit insurance—but with the enhancement that the MARKET provides a great deal of the risk discipline that we’d like. This, eludes us under a structure when we believe government agencies can adequately police risk, no matter how well-meaning.
I file this under health care reform because the Congress is contemplating all manner of new regulations, many of which introduce the same challenges hidden so innocuously under the FDIC’s popularity. Congress has a chance to do it right and a history of doing it wrong. And as well-intentioned as a government insurance agency might be, a “government option” will underperform a market-based solution that correctly structures the game.