FDIC OPTIONS PAPER ON DEPOSIT INSURANCE: COVERAGE LIMITS
Editor’s note: This is the third in a series of articles that will take a more in-depth look at the three major issues raised in the FDIC’s options paper on deposit insurance reform. The FDIC would welcome banker comments on these issues, as would we.
The third and last major issue addressed by the FDIC options paper on deposit insurance is how to set coverage levels. To date, coverage limits have been set on an ad hoc basis, with Congress revisiting the issue from time to time and establishing a new limit. Since 1934, the basic coverage amount has increased five times, from $5,000 to $100,000. The ad hoc setting of coverage limits results in fluctuations in the real value of deposit insurance, the paper notes. Most of the increases have more or less been consistent with cost-of-living adjustments, except for the 1980 increase to $100,000, which was much higher than needed to keep pace with inflation.
Based on the CPI, the current $100,000 coverage limit has declined in real value by half since 1980. “This raises the question of whether Congress wishes to continue providing the same level of insurance protection for consumers in real terms, or to allow the coverage level to erode in value by maintaining the status quo,” the paper states.
Coverage limits represent a “balance between the goals of deposit insurance [protection of small savers, promotion of financial stability, and maintenance of the viability of small banks], on the one hand, and the need to limit moral hazard and the risk to taxpayers and the insurance funds, on the other,” according to the options paper.
The immediate effect on the BIF and SAIF fund balances and the risk to the funds of an increase in coverage is uncertain and the long-term effect even more so, the FDIC says, and further analysis is needed. One preliminary estimate of the immediate effect of a doubling of the coverage limit is that about $230 billion of uninsured deposits would immediately become insured and reduce the reserve ratios of the combined BIF and SAIF to about 1.28 percent.
The long-term effect depends on whether an increase in coverage would cause a change in consumer and business behavior leading to a larger proportion of new wealth being placed in deposits or existing assets transferred to deposits. The FDIC suggests that in the long run a coverage increase might not change the amount of insured deposits because consumers already have the ability to place all their assets in insured accounts by using multiple account coverage or spreading deposits among different banks. On the other hand, changes in demographics—an aging population with a preference for CD investments, decreased issuance of Treasury securities as the nation enjoys budget surpluses, or increased financial market volatility could result in a shift of household assets into insured deposits.
The paper also discusses whether an increase in coverage would increase insurance losses in the event of bank failures. Some view the 1980 increase to $100,000 as playing a key role in the savings and loan crisis, as brokered deposits provided funding for high risk institutions. The FDIC notes, however, that a confluence of many factors explains the magnitude of the crisis.
Higher coverage levels are not likely to increase systemic risk because of the minimal effect they would have on the magnitude of risk posed by large institutions, the FDIC states. For these institutions it is the implicit guarantee that uninsured deposits or creditors would be protected (too big to fail)—not explicit coverage limits—that will result in high losses. The FDIC suggests that ways other than raising the coverage limit also should be explored to level the playing field between large and small banks. Examples given include “haircutting” uninsured deposits or creditors in the event of a large bank failure, or assessing large banks for more of the costs of too-big-to-fail protections.
The paper also addresses small bank funding issues. As small banks find it more difficult to fund operations with deposits, they will turn to other more expensive and interest-rate sensitive funding sources, such as FHLB advances. But funding with FHLB advances versus insured deposits does not reduce the risk exposure or loss severity to the insurance funds or taxpayers when a bank fails, because FHLB advances are fully secured and stand ahead of the FDIC in liquidation. In addition, when banks fund themselves with deposits, the FDIC at least collects premium income.
The options for setting appropriate coverage limits outlined in the paper include:
The options paper is posted on the FDIC Web site (www.fdic.gov), along with a series of questions designed to elicit public comment. Viewers can respond to the questions directly on line. Among the questions posed on coverage limits are: whether the coverage limit should be indexed to prices, income or wealth; whether a higher coverage limit would address funding concerns at smaller institutions and allow them to compete with large institutions for deposits; whether full coverage, or other limit higher than basic coverage, should be provided for municipal deposits; whether the FDIC should provide optional excess coverage; and whether deposit insurance rules regarding multiple account coverage should be simplified.
Note: Previous articles in this series covered the issues of pricing risk at individual banks (Sept. 8 edition of Washington Weekly Report) and funding deposit insurance losses over time (Sept. 29 edition).