Thursday, June 8, 2017

A radical proposal to eliminate the FDIC

OK.  This will probably brand me a hopeless radical - a naif - someone with such an absurd fundamentalist faith in markets that it's just not worth talking to me.  But, here goes.  I propose we get rid of the FDIC.  Just get rid of it.  Let savers fend for themselves.

What could happen?  Well, there was a time, I believe, when bank CFO's would actually be accountable for losses and they would take out private insurance policies.  Or maybe, a private deposit insurance market would develop for banks.  Or clearinghouses that would backstop failing banks.  Or, maybe banks would publish their balance sheets and depositors would consider the riskiness of their portfolios before depositing their cash.  Maybe banks will actually end up being less leveraged, and the system will be more safe.  It seems like all of these developments might be better than the system we have.  In a way, I think many of the major issues in banking today come down to public deposit insurance that misprices its policies so that banks can get too leveraged or too big, etc.  It seems like a lot of problems could be solved simply by pricing deposit insurance more efficiently.

I don't think any of that needs to happen.  In fact, I suspect that in an unregulated market, there wouldn't be any deposit insurance, because there would be no demand for it.  Depositors would only give the slightest attention to the books of the banks where they made their deposits, mostly just depending on brand reputation as a signal.  And, I think this would lead to a market that you might call a sort of crazy Wild West.  I think you'd end up with banks that were highly leveraged - not 10 to 1 or even 20 to 1 or 30 to 1 - but, basically with no equity at all.  Depositors would be drawn to deposit in those banks.  Some might say duped.  But, I say we should try it.  Even if that happens, I think we'll be alright.  I think things will work out just fine.  I've been thinking about this, and I even have come up with a name for this proposal.  The name for these new banks would be "money market funds".

Wait.  Maybe you object.  We already have a thing called money market funds, and they are exactly the opposite of this.  They aren't leveraged at all.  They are generally very safe.  Don't they basically meet my description, though?

Oh, the leverage thing?  Well, a bank is 90% leveraged because they have 10% in equity capital and 90% in deposits (which are liabilities to a bank).  A money market fund has 100% deposits.  The only reason we call it unleveraged is because money market funds don't have FDIC insurance.  FDIC is a magic formula that turns equity into liabilities.

Safety?  How many failed banks required FDIC actions after 2007?  Hundreds?  How many money market funds?  As far as I know, just one, at the height of the crisis when CPI prices collapsed by 2% in a single quarter - the Reserve Primary Fund.  It came up short in the amount of one or two billion dollars.  I believe savers received 99.1 cents on the dollar.

There is about $2.5 trillion parked in money market funds.  And, they invest in reasonable short term investments.  How is this not proof of concept?  What am I missing?  How is FDIC insurance and the complex web of regulation surrounding it in order to maintain safe deposits at commercial banks anything but a kludge intended to maintain an anachronistic set of financial institutions which keep creating systemic risks by mismatching assets and liabilities?

It seems like there is a place in the economy for financial intermediaries that take on credit risk with local entrepreneurs, commercial real estate investors, etc.  It seems like there is the potential for a bank with operational capital to capture a decent profit in that business.  What's the point of having that institution also take in deposits just to buy MBSs, sell and retain long duration mortgages, buy treasuries, etc.?  In a world with money market funds, why does this still exist?  Why shouldn't we have banks that take credit risks, with liabilities and capital that match the maturities and risks of that business, and banks that don't take credit risks, and meet the demands of depositors with short maturities?  Instead, it seems like we are mixing these mismatched assets and liabilities and we are cobbling together a bunch of capital requirements which are determined by the bank's assets, but which really are aimed at meeting the demands of liabilities that really have no business being involved in the funding of those assets.

Is there something I am missing here?

It's not like we would be in some sort of unknown universe without FDIC insurance and capital requirements.  And the downside seems to be that once in a lifetime, if we learn nothing about creating a more stable macro economy, a few savers lose a penny.


  1. Lots of interesting ideas.

    I guess the U.S. banking model has been, "Borrow short to lend long, and make money on the spread."

    A bad model? Back in the 1980s, when I worked as a (very) junior lobbyist for the S&L industry, we lionized ourselves as doughty "intermediaries" between the huge demand for short-term deposits but the huge demand for long-term loans.

    For such heroics, we deserved comforts, such as protection from commercial banks and fleeting market whims.

    It does raise a question: What if there is a huge supply of short-term deposits, but a need for long-term loans?

    Maybe private mortgage and deposit insurance would work.

    AIG was an example of private-sector bond insurance, purchased by sophisticated institutions. AIG collapsed. Private financial insurance can fail, and has in recent history.

    In the present day, I think we are stuck with our system.

    Even my favorite tweak seems outlandish: Drop all other regulations, but require banks to finance perhaps 25% of lending by issuing convertible bonds.

    Obviously, if the bank flounders, the shareholders get wiped out, and the (sophisticated institutional) convertible bond holders take over, first forming a bondholder committee and then bringing in new management etc.

    The convertible bondholders would not buy the bonds to begin with, unless there are certain covenants in place.

    It is interesting what the banking lobby is seeking today. They are not seeking freedom from the federal government, so as to issue private deposit and mortgage insurance. They are not offering to keep a fat 25% in reserves to avoid other niggling requirements.

    In fact, if you go to the ABA website, they seem rather content.

    1. The demand for long term debt is mostly due to federal policy that encourages the 30 year fixed mortgage, which is largely funded outside the commercial banks. I don't know if it will make the final print but I propose a sort of floating rate mortgage in the book that I think solves that problem without creating cash flow risk to the borrower. A floating rate mortgage for a bank is like a short term loan. The mismatch problem is artificial.

  2. KE-

    As I am sure you know, adjustable-rate mortgages are common, so maybe a forced migration to 100% ARMs is doable.

    Many years ago, I proposed people taking out very large ARMs could go short on bonds in some way.

    But then, a bank with a portfolio of long-term loans could do the same thing. Constantly expiring options, that sort of thing.

    (Although I will be surprised if we see higher interest rates in our lifetimes).

    OT: Corbyn the new PM in UK?

    Housing is called a "crisis" there. Adair Turner points out banks have poured trillions into extant real estate.

    I will say it again: If we want voters to embrace free markets…shouldn't we try to make free markets work for voters?

    Do globalized wages and housing shortages appeal to the average voter?

    1. One idea I'm trying to think about is that there is no reason that the payment rate and the interest rate have to be bundled. At least part of an adjustable rate can be capitalized safely. And, it actually is pretty easy to do because having them bundled is such a pain in the ass for lenders, especially considering prepayment issues, that borrowers pay a huge premium in order to get a stable payment rate. But, borrowers only care about the stable payment. They don't care about the actual interest accrual. Banks don't care about the payment rate. They only care about the interest accrual. This is a clear arbitrage opportunity, which would avoid an interest rate premium that averages nearly 2% over time. I can't believe we haven't seen this sort of mortgage tried before, especially on mortgages with reasonably low LTVs.

  3. Interesting discussion. I like BC's convertible bond suggestion. Re the FDIC, I'd like to see how an interim step worked where the FDIC only guaranteed say 95% of deposits over say $25,000. One thing to consider - I think deposits are like $11 trillion, so more than 4 times the amount in MMMFs.

    1. To me, it just seems like we have a status quo bias. For depositors and convertible bond holders on the liability side and for mortgage borrowers, agency debt issuers, etc. on the asset side, in today's economy, there are plenty of alternatives to the commercial bank. They might still serve an important role in localized business and commercial lending. It seems like that could be funded by some broad range of bonds and equity. Maybe that unregulated model would end up very heavy in equity capital. I like the convertible bond idea too. Yet, what's the point? Why are we propping this model up with an ever growing package of guarantees and mandates? I like your idea of a partial guarantee. I'd say if a money market fund ever breaks the buck, there should be some clearinghouse set up, funded by the industry, that guarantees 95 cents immediately to all depositors until it reaches $1 again, then the fund is liquidated or sold. That probably would never cost a penny, but it would serve as a backstop for liquidity. I think Ed Glaeser? has a paper about how bank runs never or rarely led to losses of more than a few pennies, even back in the big bad old days. I am coming around to the idea that deposit insurance and fixed rate mortgages are much more trouble than they are worth.

    2. So here's why I support the status quo to some extent. I went to college but my parents didn't. Nor did their friends. They're smart people but didn't learn much about finance. A couple of them thankfully found the Vanguard model. Even so, their benefits from that model end up being fairly tenuous because it's based on a few hours of reading, so all it takes is one slick salesman and they're buying some insurance product or something. I want them to have a zero risk option because they don't have the interest or inclination to read 3 or 4 books like Random Walk Down Main Street. Also, I don't think society benefits from having people with less than $100,000 making credit judgements about various banks. Including that those people have better things to do.

    3. The problem of protecting people from themselves in such a complex and important topic as finance is certainly a conundrum.

      On the other hand, my point is that we have that system now, in money market funds. They are very safe, and that safety doesn't really require the diligence of individuals. People are much more likely to be taken in by shady dealers in complex things like annuities or risk taking investments than by firms giving them a checking account and investing the cash in treasuries.

    4. All very good points.
      Actually, I remembered another idea I liked better than FDIC insurance. Checking accounts at the Post Office. 0% interest. The Post Office is just a middleman. Treasury is the effective borrower, so all taxpayers benefit from the Treasury borrowing at 0% and issuing fewer bills, notes and bonds.