FDIC Caps Should Be Retained: Alan S. Blinder, R. Glenn Hubbard 2008-10-02 22:01:00.0 GMT
Commentary by Alan S. Blinder and R. Glenn Hubbard
Oct. 3 (Bloomberg) -- As the financial crisis that began with subprime mortgages deepens and spreads, the air is full of bold ideas -- some good, some bad.
One clear and present danger is that some pretty good ideas might morph into pretty bad ones as panicky people lose sight of the basic objective of whatever rescue package is adopted: to restart the economy's blocked credit-granting mechanisms so that the whole economy doesn't fall into the abyss.
We refer in particular to expanding Federal Deposit Insurance Corp. coverage, which has been capped at $100,000 per account since 1980. The two of us come from different political parties, and we differ on many policy issues. Yet we were struck that Senators John McCain and Barack Obama (and many others, on both sides of the aisle) have advocated the same, measured policy response: Raise the FDIC limit to $250,000, perhaps temporarily.
This is a responsible approach that, if it helps restore depositor confidence, can be one component of a rescue package.
Others have suggested going much further -- to eliminating the FDIC cap and having the government insure every dollar on deposit in every bank in America. Wow! Like the Final Jeopardy round, it has left us wondering: If this is the answer, what was the question?
Let's start with a big question. Is it the answer to the interlinked problems of falling house prices, foreclosures, and bad loans and securities sitting on banks' books -- which is what the $700 billion bailout bill was aimed at?
No. The other huge problem at present is the unwillingness of banks to lend to one another, partly because of panic and partly because they are so thinly capitalized.
Simply Afraid
More deposit insurance does nothing to address that either. Furthermore, much of the panicky deposit outflows have actually come from insured depositors. People are simply afraid.
Is unlimited deposit insurance a good way to restore confidence in the banks?
We wonder. A huge expansion of FDIC coverage would immediately leave the deposit-insurance fund woefully undercapitalized, thus requiring a very large infusion of money. The last thing we want to do is shake confidence in the soundness of the FDIC, which has been the only safe harbor in the storm. (Remember how giant investment banks fled into the protective cover of FDIC-insured banks?)
Uncapping deposit insurance would force the FDIC to raise the premiums it charges banks very substantially, perhaps to rates that would damage the majority of banks, most of which have relatively few uninsured deposits. (Uninsured deposits are heavily concentrated in the biggest banks.)
Market Discipline
Might unlimited deposit insurance be the answer to another question: How can we make sure nothing like this happens again?
Certainly not. Many people have worried about creating moral hazards in many dimensions, excessively so, in our view. For example, one school of thought has long opposed any deposit insurance, arguing that banks need ``market discipline'' from watchful depositors who are worried about their money.
At the level of the ordinary depositor, this is unrealistic. But the market-discipline argument does apply to very large pools of ``wholesale'' money, which is also, by the way, very ``hot'' money. Only very large, sophisticated depositors can, and should, exercise ``market discipline'' over banks.
As one example of moral hazard, numerous economists have argued that setting deposit insurance at too high a level back in 1980 created an incentive for the executives of troubled savings and loans to ``bet the bank'' on risky loans, thereby creating a game of ``heads we win, tails the government loses.''
`Heads-Tails'
If the gambles paid off, the S&L would be saved by the high interest rates it earned. If the gambles failed, the insured depositors wouldn't lose a cent. And this game was played many times, with mostly losers.
One hundred percent, blanket deposit insurance would, of course, create a much bigger ``heads-tails'' problem for the future. By eliminating all risk to depositors, it has the potential to erode bank credit standards severely.
Finally, is 100 percent coverage the answer to the question: What is good long-term deposit insurance reform?
No. Perhaps the most fundamental problem of all is that, once we start going down this road, there is no logical place to stop. Insuring 100 percent of bank deposits would probably induce massive outflows from money-market mutual funds into banks, something that started to happen last week anyway. That, in turn, would probably induce the government to provide 100 percent insurance to all money-market mutual fund balances, as the Treasury at first proposed.
Haste Makes Waste
Doing that would precipitate massive outflows from other short-term funds and instruments that compete with the now ultra- safe money-market funds. Since assets form a continuum of riskiness, there is no logical end to this process, short of having the government insure all risk. That would really mean foisting all risks onto the backs of the taxpayer.
An apposite example of how haste can make waste happened only days ago when the Treasury initially proposed insuring all money-market mutual-fund balances without limit. Treasury apparently forgot that such overly generous insurance -- much better than FDIC insurance for banks -- could seriously undermine the nation's banks. So the proposal was limited to money already on deposit on Sept. 19.
It is generally bad practice to make major long-run changes on the fly in a crisis atmosphere. Abolishing the limits on FDIC insurance might be another example where the law of unintended consequences comes back to bite us rudely on the nose.
The FDIC has already played a vital role in this crisis, and should continue to do so. It has truly been the Rock of Gibraltar in the storm. But changing a responsible proposal to raise the insurance cap to $250,000 shouldn't be allowed to morph into an irresponsible and dangerous proposal to abolish the cap. Even in a crisis, it is wise to look before you leap.
(Alan S. Blinder, former Federal Reserve vice chairman, is a professor of economics at Princeton University. Blinder is also affiliated with Promontory Interfinancial Network, which could be affected by changes in FDIC rules. R. Glenn Hubbard, former chairman of President George W. Bush's Council of Economic Advisers, is the dean of the Columbia Business School. The opinions expressed are their own.)