Modern Banks and the Antique Supervisor — How the FDIC Became Outdated
Introduction
During the 2008 financial crisis, the Federal Deposit Insurance Corporation (FDIC) faced a significant challenge when it had to resolve Washington Mutual (WaMu), the largest failure in history. The FDIC’s outdated structure and inability to adequately protect large, complex, connected banks and credit markets contributed to the destabilization of the financial system. This article explores the reasons behind the FDIC’s outdatedness and the need for its reimagining and reorganization.
The Origins of the FDIC
The FDIC was established 90 years ago in response to the bank runs during the Great Depression. It aimed to protect depositors by guaranteeing a minimum amount of their bank deposits. This deposit insurance helped restore confidence in the banking system and reduce the likelihood of runs on banks. In its early years, the FDIC’s influence was significant, with a coverage rate of 90% of commercial bank liabilities.
The Changing Landscape of Banking
Over the years, banking has transformed, moving away from a demand-deposit-driven model that fueled the bank runs of the past. Banks diversified their liabilities, relying less on demand deposits and more on other types of short-term funding like federal funds market, certificates of deposits (CDs), repurchase agreements, and commercial paper. These non-deposit liabilities were not insured by the FDIC, and their growth weakened the FDIC’s influence.
The FDIC’s Shrinking Coverage
As nontraditional liabilities increased in the banking system, the FDIC’s coverage decreased. By 2008, the FDIC only insured 25% of commercial bank liabilities, compared to the 90% coverage in 1952. The FDIC’s inability to adapt to the changing landscape of banking meant that it could not adequately protect depositors and creditors when crises occurred.
The FDIC’s Role in the 2008 Financial Crisis
When Washington Mutual failed in 2008, the Treasury and Federal Reserve wanted the FDIC to bail out its creditors, but the FDIC refused due to the high cost and moral hazard concerns. The FDIC’s lack of adequate resources and outdated structure led to the destabilization of credit markets, contributing to the collapse of Wachovia, the fourth-largest US bank. This demonstrates the FDIC’s incapacity to protect the banking system from non-deposit runs.
The Need for FDIC Reform
To ensure the proper protection of creditors and the stability of financial markets, the FDIC needs to be reformed. One potential solution is the merger of the FDIC with the central bank, similar to Lord Mervyn King’s “Pawnbroker for All Seasons” (PFAS) proposal. Under this system, the central bank would also serve as the deposit insurer, insuring short-term liabilities and requiring banks to preposition collateral for their obligations. This would reduce the FDIC’s need for supervision and enhance the overall stability of the financial system.
The Challenges and Uncertainties of FDIC Reform
Implementing FDIC reform comes with challenges and uncertainties. Estimating the appropriate haircuts for assets to guarantee liabilities and maintaining the independence of the regulator are significant concerns. The PFAS proposal has never been tried before, and its efficacy remains uncertain. However, it offers a potential solution for addressing the FDIC’s outdated structure.
The FDIC’s Future and the Need for Action
As the banking system continues to evolve, the FDIC’s outdatedness becomes a pressing issue. While the system has become more robust in recent years, the risks associated with runnable bank liabilities still exist. The FDIC’s coverage is not back to pre-GFC levels, and the post-GFC reforms may lead to the potential exhaustion of deposit insurance. It is crucial for the US government to address these issues before the banking system’s fragility leads to another crisis.
Frequently Asked Questions
Q: What is the FDIC?
The FDIC, or Federal Deposit Insurance Corporation, is a US government agency established to protect depositors and resolve failed banks. It provides deposit insurance coverage up to a certain limit to ensure the stability and confidence in the banking system.
Q: Why is the FDIC considered outdated?
The FDIC’s structure and coverage have not kept up with the changing nature of banking and the risks associated with non-deposit liabilities. As the banking system has evolved, the FDIC’s influence has decreased, making it incapable of adequately protecting depositors and creditors during crises.
Q: How does the FDIC’s outdatedness impact the financial system?
The FDIC’s outdated structure and limited coverage can lead to destabilization in credit markets and have a cascading effect on the banking system. The inability to properly resolve failed banks and protect creditors can contribute to financial crises and unnecessary banking distress.
Q: What reforms are needed for the FDIC?
Reforming the FDIC requires reimagining its role and aligning it with the modern banking landscape. One proposed solution is the merger of the FDIC with the central bank, as suggested by Lord Mervyn King’s Pawnbroker for All Seasons proposal. This would ensure the proper insurance of short-term liabilities and enhance the financial system’s stability.
Q: Are there any challenges to FDIC reform?
Implementing FDIC reform comes with challenges and uncertainties. One significant challenge is accurately estimating the haircuts required for assets to guarantee liabilities. Additionally, political economy issues may arise due to the immense power of the merged regulator, which can affect its independence and credibility.
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