The FDIC could offer a specifically determined risk-based premium, according to the FDIC’s own assessment of risk, for different types of deposits across the financial intermediation spectrum, including pensions, insurance companies, investment banks and the host of new innovative financial institutions that are arising. This would simply allow any financial institution to apply for FDIC insurance. The institution could then pay the FDIC-stipulated premium and receive coverage or choose not to participate.
With a well-formulated set of FDIC premiums, market competition would gradually drive investors towards the insured financial institutions, because they would be safer. This would work only if moral hazard were eliminated through bailouts that encourage financial institutions to flee FDIC coverage in the belief that they will be helped by the government in time of crisis even without FDIC insurance. This means that the FDIC insurance expansion would have to be carried out in tandem with the ending of the Fed’s IOER policy.
The government would not have to help financial institutions in times of crisis, if enough of them were part of an efficient bank insurance system anchored by an expanded FDIC. This would make the expanded FDIC insurance policy a means of slowly halting the expansion of uninsured banking and begin pulling the fragments back into an insured centre of banking. This would simultaneously reduce the liquidity problem.
To work well, the FDIC would also need to drop the policy of a fixed risk- based premium for each insured financial institution. Rather, since the amount insured becomes increasingly risky as the amount of deposits increases, the FDIC premiums should also rise in accordance with the rising “marginal cost” of the amount of deposits insured. The FDIC-offered schedule for each risk-based premium for each financial institution should rise in segments as the quantity of deposits insured rises.
Supply by firms is offered at a lower price for each unit of a lower quantity supplied. When the price of each unit rises, firms offer more quantity at a higher price. Firms face an increasing cost of production for a higher quantity of units supplied because of constraints on resources, which become increasingly scarce as more resources are used.
This is also seen in private insurance. For a large excess (deductible) of the insured amount, the insurance premium is low. For a lower excess, and therefore a greater quantity of insurance provided, the insurance premium rises. These excesses are highly variable in private insurance markets, with the result that the cost of insurance rises as the quantity of insured dollars increases.
Insurance, just like the production of all goods, supplies the coverage or output of the insurance company, as in a normal upward-sloping supply of any good. The cost of insuring more goes up as the amount of coverage rises. This means that the “marginal cost” of additional coverage rises as the amount of coverage increases, giving rise to an upward-sloping supply of insurance that equals the marginal cost of the coverage.
The FDIC insurance policy could make the amount of insured funds almost unlimited for each type of institution insured by having tiered differentiated pricing, as in an increasing marginal cost of coverage that forms the “upward- sloping” supply of insurance coverage, or any output. Up to a certain quantity of funds supplied, the risk premium would be the base level. For the next additional set of funds to be insured, the risk-based insurance premium would rise, and this rise in the FDIC premium would continually increase as the amount of insurance of funds increases.
The other issue is information revelation. The FDIC would need to induce transparency in terms of the balance sheets of the institutions to which it offers insurance. The FDIC could do this by offering a higher insurance premium the opaquer the balance sheet is of the institution applying for insurance coverage, and by conducting (or outsourcing to other federal agencies) “stress tests” of financial institution resilience like those that began in the United States after 2008.
If the FDIC prices well, shadow banks would start joining the system. By giving investors confidence in the solvency of institutions, and with the institutions voluntarily allowed to join, then greater participation in the FDIC would decrease the liquidity problem. Once solvency is guaranteed more and more by the FDIC, liquidity becomes less of a problem – although it is still a problem.
The first problem of the current liquidity system is that the Fed operates it without any budgeting of the loans being offered and in any fashion it pleases. For example, there was a $1.5 trillion sale of mutual funds and ETFs in the first quarter of 2020 that caused a short-lived bank panic. The Fed intervened by providing massive liquidity in the short-term Treasury debt money market (Tooze 2021).
A line of credit can be added to the annual congressional budget for this liquidity provision. Irving Fisher (1932) wanted a facility to be devised that guarantees loans for banks in times of a liquidity crisis. The US Treasury can indeed provide this service by guaranteeing loans made through a designated facility, using the line of credit approved by Congress, to provide loans during a liquidity crisis.
For example, a facility already exists in the United States that is designed for exactly this purpose. Rather than having loans being made by the Fed in an ever-expanding way, uncontrolled and outside the US Congress’s budget, the role can be taken over by the on-budget Treasury’s Federal Financing Bank (FFB), which was established in 1973 for exactly such a purpose. The FFB’s website (https:// ffb.treasury.gov) describes its role thus:
“Congress created the Federal Financing Bank (FFB) in 1973 to help meet the demand for funds through Federal and federally assisted borrowing programs, and to coordinate such borrowings with overall Federal fiscal and debt management policies. The mission of the FFB is to coord- inate these programs with the overall economic and fiscal policies of the Government, to reduce the costs of Federal and federally assisted borrowings from the public, and to assure that such borrowings are financed in a manner least disruptive of private financial markets and institutions.”
The US Treasury FFB could be allocated a credit line in the annual budget, including a special emergency catastrophe line of credit. The FFB could then coordinate with other agencies the allocation of loans needed in the event of a crisis in the global financial system. The FFB could use other agencies, including the Federal Reserve System and FDIC, to carry out any such operations, which would then be overseen by the Congress budget process and could include the buying of Treasury debt.
A complementary way to bring together Treasury debt for liquidity use, while also enhancing FDIC insurance against insolvency, would be to build a reserve of private Treasury debt directly within the FDIC. What would help bring shadow banking into FDIC insurance would be the provision of an intermediate step towards FDIC insurance.
The FDIC could offer to hold Treasury debt for any mutual fund, ETF or other financial entity, which it could add to or subtract from at will. The FDIC could then designate the financial entity as “FDIC-registered” rather than FDIC- insured. The FDIC registration could include a rating tied to the amount of Treasury debt deposited at the FDIC relative to the entity’s total assets. This would work in the same way as the FDIC’s current practice of offering a different deposit insurance premium based on its evaluation of the bank’s asset risk.
The FDIC would thereby gather a pool of Treasury debt supplied voluntarily by shadow banks, just like the reserves of Bagehot’s Bank of England. The FDIC would then allow the lending of pooled Treasury debt to any registered financial entity during a panic. Alternatively, the FDIC could provide pooled Treasury debt to the FFB as collateral for loans made by the FFB to banks for sudden liquidity needs, so that the FFB would incur almost no budget expense in making the loans under the 1990 Federal Credit Reform Act. This would encourage shadow banks to register their Treasury debt with the FDIC. With the Fed’s IOER and IORB rates eliminated, the shadow banks would enjoy a normal interest rate yield on their reserves of Treasury debt held at the FDIC. There would be no distortion from such a liquidity policy, and no moral hazard.
In turn, the FDIC insurance would become more attractive to FDIC-registered financial entities, as in lodging Treasury debt the FDIC would be able to learn about the entity’s risk structure and could offer a certain FDIC insurance risk premium. Competition between shadow banks would drive them through the door opened by the FDIC to obtain liquidity insurance and insolvency insurance through FDIC deposit liability insurance.
A twofold plan of voluntarily inducing insolvency coverage across the global financial system through FDIC insurance and offering special liquidity during crises through the FDIC’s pooling of US Treasury debt would provide a global finance insurance system. By continually monitoring and adjusting accordingly, both the FDIC premiums and the pooled Treasury debt through FDIC registration would make the banking insurance system increasingly efficient and increasingly global in coverage.
The elimination of moral hazard in banking always remains a problem. A perfect global financial insurance system is impossible. But by basing the insurance in the United States and building it around the use of US Treasury debt by financial institutions around the world, the global financial insurance system could be resurrected. This would decrease the frequency of financial crises, and even eliminate many of them.
There are country-specific deposit insurance systems in a vast number of nations around the world. The European Union is actively trying to design and implement an EU-wide deposit insurance system. Global flows across countries make national bank insurance systems difficult to manage.
All the individual national deposit insurance systems can complement the expansion of FDIC insurance and FDIC Treasury debt registration in a fiscally responsible way. A coherent Federal Reserve and international central bank policy after the Covid-19 pandemic is possible and desirable.
The Fed has tried to provide liquidity to the banking system through its reserves. The FDIC currently does not normally provide any use of its reserves for liquidity in the banking system. Therefore, the two systems have continued to operate in parallel and more haphazardly, while finance institutions grow outside both the FDIC and Fed systems of banks.
The solution is to bring together the ability to insure against both insolvency and illiquidity in an evolving and innovative financial world. A key to this is that the US Treasury short-term debt is the main source of liquidity throughout the financial system, including FDIC-insured banks, Federal Reserve System banks and the shadow banks engaged in money market funds, mutual funds, ETFs and person-to-person payment systems and blockchain coins. All the shadow banks must resort to finding US Treasury debt for liquidity when their funds experience a sudden massive withdrawal, as Clayton (2021) describes.
Aggregate risk in the innovating financial sector, as based on US Treasury debt for liquidity, was the main concern recognized by the US Financial Stability Oversight Council, under US Treasury auspices, as Omeokwe (2021) describes.
The evaders of FDIC insurance continue to grow. The Fed continues to handicap the “good” banks in the efficient FDIC system by excluding the “bad” shadow banks that earn more profits through non-FDIC- insured money market accounts. This encourages more diffuse forms of shadow banks to emerge and makes banking insurance as an efficient social insurance component ever more distant.
After 2008 the world was still in a state of prolonged fear of global financial crisis. The 1978 zero-inflation-rate law had long been forgotten, and the Fed was operating at odds with several other laws through its new policy of massive purchases of mortgages and payments directly to banks. The Fed’s mortgage purchases have continually violated the 1974 Congressional Budget Act and the 1990 Federal Credit Reform Act, which together require the US Congress to budget for the expected costs of buying loans.
The Fed started paying interest to private banks in 2008 on all reserves they held at the Fed. This violated the spirit of the 2006 Financial Services Regulatory Relief Act, which allows interest payments on reserves (starting in 2011), with the legislative background statements making it clear that this was to be interest only on required reserves and not on reserves in excess of what was required. By paying interest on all reserves, the Fed essentially transferred US inflation (tax) revenue from the US Treasury to the private banks, which violates their original by-laws that all interest earnings must be transferred to the US Treasury after subtracting the cost of running the Fed.
After the 2008 bank panic the Fed further violated its own by-laws, which had historically required Fed actions not to favour any one sector of the economy, on the grounds that the Fed should be an unbiased foundation for conducting monetary policy. The Fed simply changed the by-laws to allow it to subsidize the bank sector through the interest payment to banks on all reserves and through buying mortgage-backed securities, which were the weakest asset group on bank balance sheets.
The gold standard had kept average inflation near zero. Dropping this basis for monetary policy, trying to reacquire the essence of the gold regime through a zero-inflation-rate target mandated by law in 1978 but then discarding this target drove the United States towards an increasingly disparate money and banking policy, with the efficient bank insurance system based on the FDIC becoming a shrinking enterprise.
Our central banks evolved during times of metallic standards for currency. They could keep only enough reserves as were likely to be needed in the event of a bank panic. Central banks suspended the metallic standards as wartime needs arose and have long financed war by their governments by means of buying the government debt through new money.
Although the inflation tax is controlled by how much Treasury debt the central bank buys and does not sterilize, explicit income taxes require legislation. When the inflation tax goes up during a crisis, markets build in the expected inflation into energy prices, gold prices and government long-term debt interest rates. Sustained high inflation causes lower economic growth and higher tax rates on income.
Financial markets are highly flexible, adaptive, and innovative. Risk can be diversified through capital allocation within a mixed portfolio. Markets strive to anticipate normal business cycle risk, financial volatility, and the rare collapse of markets.
Financial intermediaries create capital markets. These entities specialize in different types of capital risk. They act to create a high real return on capital given the laws and regulations in which they operate.
Aggregate risk, just like the aggregate price level, is the risk for the whole economy. Aggregate risk is different from individual risk to any one person or firm, or “idiosyncratic” risk, because of the inability to pool and eliminate aggregate risk through private, financial-intermediary-diversified capital holdings. The whole sector of financial intermediation provides a range of insurance against as much risk within capital markets as is possible, but it typically excludes aggregate risk.
Aggregate risk for private financial intermediaries is aggravated when competition drives these intermediaries to minimize consideration of this type of risk as long as the government covers aggregate financial risk. Whereas the global business cycle creates volatility for the globalized economy that is hard to insure, governments take on aggregate business cycle risk in a variety of ways, including unemployment insurance, health insurance and insurance of the financial sector. A meticulous bank insurance policy gauges the normal business cycle defaults of financial institutions, along with the rare risk of contagion across a set of financial institutions because of their holdings of a common bad asset. Private insurance charges a premium in the good state and pays out the insurance in the bad state, and a comprehensive government bank insurance can be designed in the same way.
During the Great Depression, as the malaise it engendered continued throughout the 1930s, Keynes (1936) suggested the government step in and invest the savings that the private bank sector could not invest. This justified government intervention in markets in wide, unspecified, ways. Fisher (1932, 1933) instead stated that regulation of the bank sector needed to be reformed since it was the private bank credit that collapsed during the Great Depression, not the government money supply.
Today’s central banks follow the advice of Keynes and not of Fisher. Rather than reforming the bank insurance system at its root causes of dysfunction, the Fed chose to intervene heavily in capital markets by fixing interest rates, without restraint or checks on its power to subsidize in extraordinary ways. The dysfunction led to growing sectors of the financial system finding themselves outside the bounds of the FDIC and the Federal Reserve System.
Reform can be enacted by inducing financial intermediaries back to the FDIC system. A tax through inflation is bad. A tax on the global economy through usury prohibition via enforced negative real interest rates on Treasury debt is worse.
When fringe benefits proliferated in the United States, so that companies could pay out more income in kind without employees or the companies facing taxes on that income, after a decade of effort the US Congress finally reigned in this tax avoidance with title V, subtitle C, “Tax treatment of fringe benefits”, of the Deficit Reduction Act of 1984, which specified what and how fringe benefits were to be taxed. This 1984 Act broke the impasse and allowed the US Congress to continue with tax reform, once the income tax base was well defined. The Tax Reform Act of 1986 followed by lowering tax rates further, inducing rising productivity and making both tax avoidance and tax evasion less worthwhile.
The 2017 US Tax Act lowered tax rates further. The world economy has been lowering and flattening out tax rates, albeit unevenly, as productivity rises steadily, and tax evasion becomes less worthwhile. This has increased world development and wealth.
Bank insurance likewise needs to broaden the base of coverage through FDIC insurance premiums and FDIC registration, which pools Treasury debt for financial intermediation. The avoidance and what can be called evasion of FDIC insurance became apparent after the 2008 financial panic and global capital market repression of real interest rates. The repression of capital has led to the repression of capitalism and the rise of political regimes favouring the allocation of resources towards their own clientele rather than to their broad citizenry. By offering bank insolvency and illiquidity insurance to all financial intermediaries, the arbitrary bank policy and capital market repression loses any justification and can simply be eliminated. In contrast, competition would drive financial companies into such a broad-based system, if they are otherwise left out of all government insurance. Broadening the base for bank insurance would lower the real cost to all financial intermediaries in the long run and stabilize global capital markets, capitalism and political systems on the basis of free exchange.
The story of inflation continues as the money supply increases in major nations aligned within the global financial system. The aggregate price level rises as the histories of money supply growth, inflation and wars coincide. Providing a reformed banking insurance system that efficiently safeguards against both global financial insolvency and illiquidity is the best way to tame inflation.
When the inflation tax goes up in markets with a broad-based, fair and transparent bank insurance system, there will be only the consequence of the cost of inflation. It will just be an increase in a single tax rate, perhaps in a new moderately high inflation episode. High inflation and hyperinflation will be different but less likely in a well-founded democracy with a fair and open tax system and with a well-insured financial system as part of an efficient social insurance policy. After 2008 populist parties arose across the Western world and the Eastern world alike, economies stagnated at the edges of the globalized financial system, just as had happened during the Great Depression of the 1930s.
Repressed global finance threatens modern democracy, in which today’s wars are fought over scarce resources, including technology financed through global capital. Allowing inflation to rise to a moderately high rate is better than allowing capitalism, democracy, and freedom to fall.
Max Gillman 