The recent multi-billion losses at JP Morgan have renewed calls to break up the largest banks and/or increase regulation of said banks. Such logic is not without its merits. The extensive federal backing of our largest banks, both explicit and implicit, reduces the market discipline facing these entities, resulting in considerable moral hazard and ultimately increased risk in our economy. The imposition of capital standards and limitations on various “risky” activities has all been directed at reducing losses to the taxpayer. I believe, however, these regulatory efforts have largely failed at containing the moral hazard created by the government safety net. It is time to try a far more direct approach: pulling back that very safety net.
Let’s start with the explicit safety net. Bank creditors, in the form of depositors, receive considerable protection from loss in the event of a bank failure. Accordingly said depositors face little, if any, incentive to monitor bank behavior. A body of academic empirical work has demonstrated that uninsured depositors do actually monitor and discipline banks. International cross-sectional studies also suggest that countries with more extensive deposit insurance schemes also have more financial crises. Clearly this extensive explicit safety net is not without its costs.
In order to limit the risk to the overall deposit insurance fund, and to indirectly both limit bank size and reliance on deposit funding, a cap on the percent of the insured deposits held by any one bank would be a reasonable place to start. The previous limit was 10 percent of the insurance fund, although that could be breached by organic growth (rather than via merger). We should reduce the limit to 5 percent and make such a hard cap. If banks want to take uninsured deposits, that’s fine. We can also continue to place the FDIC ahead of other creditors, which would result in increased market discipline by non-deposit sources of debt funding.
Only a handful of banks are currently above this limit. Of the just over $10 trillion in deposits in U.S. banks, about 69 percent are currently backed by the FDIC. Applying a 5 percent cap would limit any one bank’s holdings to just under $350 billion. As an illustration, Bank of America currently holds just over $1 trillion in total deposits, not all of which are federally insured. In fact only about a third of BoA’s deposits are non-interest bearing, and hence likely “demand deposits” that could be subject to a “run”. The vast majority of BoA deposits are in money market and various long-term savings accounts, less subject to consumer liquidity needs. More importantly about 20 percent of BoA’s borrowing is in the form of long-term debt. Limiting large bank access to insured deposits would shift funding toward long-term debt sources, substantially improving the stability of our banking system by reducing maturity mismatch.
Deposit insurance protection should also be limited to arguably those households incapable of monitoring bank behavior. Tucked away in the TARP bank bailout was in increase in the then $100,000 cap for deposit insurance to $250,000. That “temporary” cap was set to decline back to $100,000 on January 1, 2010, but was later made permanent by the Dodd-Frank Act.
Of the 117 million households in America, only about 10 million have total bank deposits above $100,000, or less than 9 percent of all American households. These same families also have incomes of over twice the median, putting these households in the top 20 percent of earners. Nor are these households without significant wealth, with total median holdings of financial assets alone of almost $600,000. Most households with deposits above $100,000, given their considerable financial wealth, demonstrate sufficient sophistication to provide monitoring of a bank’s financial condition. Even if families with bank deposits above $100,000 were to suffer a loss in deposits resulting from a bank failure, the typical family in this group has both considerable income and wealth to buffer such a hit. In contrast, the typical, or median, American household, has only about $6,400 in bank deposits, well below the previous ceiling of $100,000.
Ultimately we should go back to the pre-1980′s level of about $40,000 and limit that to total coverage per person. Such an amount appears more than sufficient to meet immediate needs. We should remember that in most bank failures, uninsured depositors are rarely completely wiped out. To add some degree of comfort we could also place uninsured depositors just behind insured but before other creditors in the chain of priority. The excessive level of deposit insurance coverage has never been about protecting families, but has always been about subsidizing banks.
Some might ask, why limit deposit insurance at all? Was not this a crisis of the “shadow banking” system? Such reasoning ignores the fact that the FDIC has increased risk in our banking system. The most obvious example is the savings and loan crisis, which cost, on net, more than the TARP. That was all small institutions funded by insured deposits. And don’t forget over 300 small banks have failed this time around, which also relied almost exclusively on deposit funding. Even in the decade after the creating of the FDIC, we still have over 400 bank failures, questioning the assertion that bank failures are primary the result of “panics” rather than insolvency.
The more difficult question is limiting implied guarantees. Changing the law is one thing, changing perceptions is another, which is essentially what drives the implied guarantees behind “too-big-to-fail”. I believe the only way we can ever truly eliminate implied guarantees is by trying the hands of the regulators. Repeal of the Federal Reserve’s 13-3 bailout authority would be the first place to start. Other slush funds, such as Treasury’s Exchange Stabilization Fund (used to rescue the mutual funds), must also be eliminated. As long as regulators have access to large pots of public money, the temptation to use such to cover up their own failures is simply too great. Ultimately, voters must also hold pro-bailout politicians accountable at the ballot box. Market discipline can also be improved by immediately imposing losses on the creditors of “too big to fail” institutions. I can think of no better place to start than Fannie Mae and Freddie Mac, currently under government control.
If we want to reduce the taxpayers’ exposure, then the more effective way, in my view, is to limit the bank safety net or at least limit the extent to which the safety backs any one entity.
Mark Calabria is Director of Financial Regulation Studies at the Cato Institute
Source: AFF Doublethink Online | Kathlyn Ehl
Source: AFF Doublethink Online | Jacob Hayutin