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One of the Clinton Administration’s more outlandish giveaways to corporate interests was its decision six years ago to provide free deposit insurance to about 92 percent of the nation’s commercial banks. The move represented a five billion dollar annual bonanza to the banking industry and billions of dollars of new risk for taxpayers.
Before she left office earlier this year, the Chairman of the Federal Deposit Insurance Corporation, Donna Tanoue, had her agency conduct a top to bottom study of the deposit insurance system. The study produced a mixed-bag of recommendations, but more importantly, provoked a healthy debate in the Congress and among the industry about the future of deposit insurance. Most of the debate has centered around the reforms’ potential effect on financial corporations, but taxpayers who funded the bailout of the savings and loan industry in the late 1980s and early 1990s know they have a huge stake in the outcome.

By far the most important recommendation, from the standpoint of both risk and fairness, is the study’s insistence on imposing insurance premiums on all depository institutions, ending the free lunch enjoyed by most of the nation’s banks since 1995.

Under the present system, FDIC stopped collecting the premiums when the insurance funds on hand represented 1.25 percent of the insured deposits — the absolute minimum reserve allowed by law. Under the system, if reserves drop below the minimum of 1.25 percent (for example, because of bank failures in an economic downturn), FDIC would be required by law to once again to impose premiums to rebuild the fund.

Thus the existing system could force banks to pay high premiumsduring periods of financial distress and none when they are enjoying fat profits as they have in recent years. Procyclical payments like that have the potential to reduce credit and exacerbate “boom and bust” banking cycles at exactly the wrong time. Instead of keeping reserves at a minimum, FDIC proposes that all banks continue paying premiums and that the insurance fund be allowed to shrink or build gradually around broad targets or ranges. This proposal is in keeping with recommendations I made to the FDIC in 1995 in objecting to the agency’s proposal for free insurance for banks.

Much more questionable, however, is a FDIC recommendation that the current insurance coverage limit of $100,000 per account be increased through a formula tied to the Consumer Price Index. The insurance coverage was raised from $40,000 to the current $100,000 level in 1980 in a surprise move by a House-Senate conference without economic analysis, hearings or even a recommendation from the FDIC. The figure was simply pulled out of the air during negotiations among various conferees. Behind the move was an intense lobbying effort by the savings and loan industry which wanted the additional insurance to help it attract large deposits which were flowing to big money center banks.

Not only do higher limits of insurance coverage make the resolution of failed institutions more costly to the insurance fund and potentially to taxpayers, but they create a “moral hazard” by which the public, Congress, regulators and financial institutions are lulled into complacency.

While the current limit is technically $100,000 per account, deposits can be maneuvered in a manner that could conceivably allow a family of four to keep as much as two million dollars under insurance coverage.

The talk of change in the deposit insurance system has prompted some independent banks to lobby for an immediate increase in the limit. Some of their friends in Congress are urging an overnight doubling of the coverage to $200,000 per account — shades of the efforts by the savings and loans in 1980 which led to the present $100,000 coverage.

FDIC’s study also raised the possibility of gradual rebates to banks when the insurance fund exceeds the outer range of targets established by the agency. Rebates, however, could endanger the growth of a “rainy day” fund that would protect the insurance fund and taxpayers against unforeseen and hidden problems in the financial system and in federal and state regulatory agencies.

When the fund amasses a significant reserve and a stronger coordinated regulatory system is in place, Congress can worry about rebates. That shouldn’t be up front in a bill designed to develop a sounder more rational deposit insurance system.

The new FDIC Chairman Donald Powell was sworn in August 30, and he should place deposit insurance reform at the top of his agenda. His predecessor opened the door with a study. The Bush Administration should now move reform forward in a legislative form, and, at a minimum, make certain that financial institutions pay premiums on the insurance that provides the glue and public confidence which holds the system together and helps generate its considerable profits. Corporate welfare in the form of free deposit insurance for banks is a prime candidate for elimination. Taxpayers have been bilked enough by massive bailouts of financial institutions in the past.