Reforming the US Banking Insurance System and its Conflation with Monetary Policy

Reforming the US Banking Insurance System and its Conflation with Monetary Policy.

The main problem with Federal Reserve monetary and “macroprudential” policies (the latter means government bank sector insurance policy) is that after 2008 the two became conflated so as to distort both sets of policies. Before 2008, it was believed that the non-FDIC financial intermediary sector could not have a bank panic and so designing an efficient ex-ante risk-based deposit insurance premium system for the non-bank banks, as they have been called, was deemed unnecessary. It was considered additional regulation that was unwanted and unneeded.

Charles Goodhart (former Bank of England Chief Economist) wrote in The Evolution of Central Banks how the mutual funds were backed by marketable assets that would be valued with the market fluctuations and somehow (it is not explained but rather claimed) always have sufficient liquidity and solvency. Additional regulation was deemed unnecessary although Goodhart is addressing the risk of the banking sector throughout his treatise, or what he called the micro function of central banks: the regulation of the private banking sector. Now we call this macroprudential policy although since the bank market was viewed as a microeconomic market that can be studied outside of the macroeconomy, the term micro policy made sense at the time (1994) of his treatise. However Goodhart and most other economists turned out to be wrong about this, as the 2008 investment bank collapse proved.

The vast majority of economists that write about the need to “re-regulate” the bank sector completely shy away, as did Goodhart, from discussion of systematic bank deposit insurance for the entire financial intermediary sector and the provision of efficient ex-ante insurance for the entire sector, although Mervyn King (2017) was clear that ex-ante insurance is indeed the goal. One might forgive Goodhart who very briefly mentions bank insurance, since at the time the FDIC still charged a single premium for all banks for each deposit insured regardless of the riskiness in their asset sheet. This was known to induce the “moral hazard” of incentivizing banks to take on more risk since than was otherwise (in the absence of insurance) advisable since their premium would not go up. Its like speeding and crashing in your car and never seeing your insurance premium go up, which it obviously does in private markets. At the economy-wide level, when a US law creates an institution such as the FDIC that provides insurance, rather than the Federal Reserve which totally failed to provide bank insurance during the Great Depression, then if that FDIC structure causes an increase in the probability of bank failure and bank runs then we call that inefficient government policy because this is the definition of causing “moral hazard,” an increase in the bad state of affairs relative to what is being insured.

Goodhart not embracing an FDIC insurance in 1994 can be forgiven because economists widely accepted that moral hazard resulted from a fixed FDIC premium. However, after the bank crashes in the late 1980s and early 1990s, economists realized that different the degree of different bank risk within each could be quantified and was in the market naturally. This gave rise to the concept that the FDIC could likewise assess the riskiness inherent in each bank’s assets and balance sheet. This realization led finally to the reform of FDIC insurance in the 2006 FDIC reform act that instituted risk-based premiums for each bank, with different banks paying premiums based on their perceived riskiness. This made FDIC insurance efficient, potentially allowing the FDIC to charge premiums for each bank that covered both idiosyncratic bank risk and aggregate bank panic risk. The FDIC keeps a reserve pool from the premiums at around 1% of the deposits insured and this allows it to offer exactly the type of reserves to finance the absorption of failing banks into other banks and stop any panic for FDIC insured banks. After 2008, the FDIC raised this reserve pool slightly, to 1.35% from 1.15% and so increased its reserves to cover aggregate risk.

While this very efficient system runs, as legislated the by the US Congress and signed into law by US Presidents Roosevelt and Bush, the Federal Reserve has never had any ability whatsoever to insure against bank panics. It then becomes a small wonder why the world looks to the Federal Reserve to insure the financial system against panics. Indeed in its inception after the 1906 bank panic, all thought the Fed was created to stop future bank panics. But it was not a Bagehot Bank of England that received reserves willingly, voluntarily deposited into it by the private bank sector. The only reserves the Fed has had throughout its history up to 2008 were a small amount of mandated reserves. This is viewed by banks as a tax. In Bagehot’s (1873) Bank of England days, the voluntarily supplied reserves certainly earned no interest but were not viewed as a tax since the private banks then could depend on the Bank of England to provide each bank with its reserves plus any additional amount of reserves that were needed (on a loan basis at a higher-than-prevailing interest rate). The Bank of England pooled reserves so that the entire banking system held less reserves overall than if there were no Bank of England, according to Bagehot, and then acted to give out these pooled reserves to stem bank panics. There was no perfect way to do this policy of bank insurance by the Bank of England, and so Bagehot wrote an entire treatise, Lombard Street, discussing how it might be done most efficiently, and if at all possible, Bagehot wanted it to be done systematically in an efficient way. This was the central bank providing private banking insurance.

Reading Goodhart’s (1994) Appendix, he describes the evolution of central banks across Europe and Japan. You see there a combination of the central bank gradually evolving to provide bank insurance policy or the legislature passing laws or “regulation” to accomplish that, or a mix of measures. The uptake is that this bank insurance policy concept is a difficult one that has been approached in a variety of ways historically.

The FDIC insurance of the 1933 Banking Act that began (on a temporary basis at first) in March 1933 abruptly ended the Great Depression as Roosevelt’s first fireside chat told the citizens that deposits were fully insured and they responded by pouring their money back into bank deposits, which in turn then lent them out and increased investment and GDP. At the time, the limit on FDIC insurance per depositor was broadly seen as sufficient to cover nearly all deposits, so it was true in this sense that all deposits were covered. The beauty of the risk-based premiums of the 2006 Act reforming the FDIC insurance system is that it perfectly fits Bagehot’s definition of devising an efficient way to conduct insurance for the banking sector. Nothing in Bagehot indicated this had to be done by the central bank. Rather Bagehot carefully details how history came to evolve in such a way that it was the Bank of England providing this deposit insurance after the finance industry in Great Britain exploded once limited liability corporations were allowed for all banks (by the Companies Act of 1862).

The US made a fantastic innovation to the scheme of how to efficiently insure the private bank sector with the creation of the FDIC. It was flawed by having a constant risk premium regardless of risk, so it was imperfect and often deemed by most economists including Goodhart to be a mere subsidization of the bank sector. This is broadly, inherently untrue, since premiums are paid with the idea of forming an actuarially fair insurance scheme whereby what is collected in premiums equals the expected pool of reserves needed to be paid out in time of crisis. With the well-recognized moral hazard of a constant risk premium eliminated by the 2006 FDIC reform, it became exactly the type of system that Bagehot envisioned, especially with the FDIC keeping an “apprehension minimum” of reserves, as Bagehot called it, in the form of the 1.35% of reserves that they hold relative to deposits insured. Bagehot at length presents different ways on how the apprehension minimum might be established. One might say he agonized over how to establish this. He recommended that it should be scientifically studied as far as was possible. It should not be 40% of 33% of deposits, some fixed number, but rather must take into consideration not just the quantity of deposits but also the quality. Those are Bagehot’s words. It means that the risk of the assets gathered by private banks from the deposits made into the bank should be part of the equation of how to determine a sufficient amount of reserves to hold relative to insured deposits so that there would be no perceived risk of a bank panic: the apprehension minimum.

The risk-based insurance system of the FDIC, not the Fed, exactly meets the criterion of Bagehot in creating an efficient deposit insurance system. Unfortunately, history in the US intervenes here and has caused the fractured inefficient insurance financial intermediary insurance system that the US now endures. This history is that the Vietnam War was financed by the Fed buying an increasing share of a growing Treasury debt to finance the war by printing so much money that it broke down the Bretton Woods gold standard. This led to inflation rising after 1971 well above the 5.3% interest rate limit that was imposed also by the Banking Act of 1933 to avoid “usurious” rates on interest. Under a gold standard, going back to 1792 in the US, inflation fluctuated around a zero trend up to 1958 when the US Vietnam War engagement began. Normal market interest rates cover the rate of inflation and then are higher to give a positive return to capital after inflation. With zero inflation as the trend, a 5.3% interest rate seemed sufficiently high that it would never be binding. With the unconsidered end-for-all-time of the gold standard in 1971 and the beginning of a fiat money world, inflation could be anything and was high then at over 10% (and is high now). Banks in the 1970s were desperate to offer a normal market interest rate that included at least the inflation rate so as to have a positive return for depositors after inflation. Credit unions, mutual funds, money market funds all devised ways to avoid the law governing FDIC-insured banks, as well as the Federal Reserve System reserve requirements, and offer a “normal” unregulated interest rate. This began noticeably around 1978. Deposits in non-bank banks germinated, then mushroomed, and have never been insured to this day, remaining outside of the FDIC system.

Since 2008, when the Fed’s reserves went into negative territory (not counting their borrowing from other central banks in Liquidity Swaps), the Fed started paying interest on reserves to build up a reserve pot such as that at the FDIC or that at Bagehot’s Bank of England. The problem was that the Fed could not lend out these “excess reserves” since they did not own them, while the Bank of England could pool them and lend them out. The Fed paid banks to keep reserves; the Bank of England took in reserves willingly offered for insurance purposes. This is a huge difference ignored today as the Fed’s trillions of reserves are viewed as some sort of insurance for the banking system, which they are not.

Largely discussed finally since the SVB collapse, the Fed still has no bank insurance policy. It had to get five banks to agree to pool their reserves held at the Fed and lend them out to First Republic Bank to avoid its collapse, just as did J P Morgan in the days before the Fed existed. This is not an insurance system. This is the Fed scrambling to pretend it insures the banking system.

An extremely easy and comprehensive solution is to allow voluntary expansion of FDIC insurance to any financial intermediary, with the FDIC determining the risk-based premium fee that it would charge. This can be offered to any investment bank, any insurance company, any pension fund, any mutual fund or exchange traded fund, or any of the new financial innovations coming into the market. How did the FDIC determine risk-based premiums for FDIC-insured banks: by looking at the assets and assessing what deposit insurance rate to set. This should be made a voluntary system for the entire financial intermediary system instead of the current mandatory system that covers of only a fraction of the financial intermediary system. Then financial intermediaries without the FDIC sticker on their door would be seen as riskier and people would go to the FDIC-insured investment bank or any such intermediary instead. This would induce most of the system to seek such FDIC insurance.

The alternative always proposed from Goodhart to Mervyn King to Thomas Hoenig even when Vice-Governor of the FDIC has been to increase capital reserve requirements such as in Basel I, II, and III. Quantity restrictions can be evaded just as any tax. They can never emulate an efficient price-based system of insurance, even if it is a semi-governmental body operating it like the FDIC. Offering price-based insurance in terms of a risk-premium with a fee schedule that rises as the amount of deposits insured rises, so that any amount of deposits at any financial intermediary can be covered, can through trial and error create an ex-ante efficient financial intermediary insurance system that can be modelled around the world and induce financial stability.

Such insurance, if all moral hazard were eliminated, would be a perfect insurance system rather than a tax, regulation, or quantity restriction that intermediaries would avoid up to the point where the marginal benefit of avoidance equals the marginal cost of complying. No inefficiency exists in a perfect ex-ante insurance system, and no margin of avoidance would exist either. In the real world, the FDIC is best positioned to offer such an insurance system, where they would allow it to evolve over time to become increasingly efficient.

With such a broad-based FDIC system the Fed would not have to print money at accelerated rates as after 2008 to finance a bank bailout and continued subsidization of the bank sector through interest on all reserves and continued purchases of mortgage-backed securities. Instead, the Fed could finance Treasury expenditure at a more constant rate. There would be fewer and fewer such financial crises causing explosions of Treasury expenditure as a result of experiencing exactly what was the long-claimed inefficiency of the FDIC that is no longer true: increasing moral hazard. This very heart of the claim against the FDIC, of it causing moral hazard, is exactly what now is ongoing and increasing as the FED bails out financial intermediaries, ex-post, after the crisis. The non-bank banks are encouraged by market competition to take increasing risk leading to an increasingly risky and volatile global financial system since they have a plausible experience-based expectation of being bailed out ex-post.

The solution is easy: Make FDIC risk-based premium coverage 1) a voluntary system, 2) offered to any financial intermediary of any form, 3) allowing unlimited deposit coverage with an increasing schedule of fees per dollar of coverage as the amount of dollar coverage increases. This is of course an upward-sloping supply curve for FDIC insurance to those familiar with economics in which the supply schedule is the upward sloping marginal cost schedule in a competitive market. A semi-government agency would want to emulate that type of supply in competitive markets if competitive markets cannot cover the aggregate risk but the agency (FDIC) could.

The reform of the FDIC to cover the entire financial intermediary sector requires Congressional legislation not Federal Reserve Action. That is the fundamental problem in reforming the banking insurance system in the US. It evolved into law from the Great Depression. It took another 73 years before the moral hazard component of the FDIC was eliminated. The 2008 crisis and the 2023 SVB crisis is sufficient to get an educated Congress to enact the reforms necessary for an efficient US bank insurance system, based on offering a voluntary expansion of FDIC coverage rather than a mandatory FDIC expansion that rightfully so would be viewed as a taxing regulation. In contrast, this can never by design of the institution come happenstance from the Federal Reserve System. US law must be changed, or the FDIC could simply reform their system as their own prerogative. My understanding/suspicion is the FDIC may not have the power to do these reforms without the US law mandating them.