Don't Quit Your Day Job…

The Federal Deposit Insurance Corporation is a federal company created to insure commercial banks in the Glass-Steagall Act of 1933.  Member banks pay a percentage of their deposits into the fund in exchange for the backing of the “full faith and credit” of the United States Government.  Seemingly, this means that any bank failures which drive the fund to undercapitalization would trigger the backing of the United States general fund.  It also means that when the trust fund is low, as it is now, the FDIC should make moves to ensure the banks it serves don’t ‘bankrupt’ the trust!  In that vein, new FDIC rules which started January 1st limit the amount of interest ‘problem’ banks can charge to 75 basic points above the national average rate (weighted by bank capitalization).

Moral Hazard

While it’s easy to disagree with any section of the guideline, it’s also easy to see why such a rule is necessary.  Banks increase their interest rates in order to attract new capital and customers.  Problem banks may increase their interest rates so much that they end up making their problems worse (namely, the amount of interest they pay, plus the FDIC insurance they pay on the money and other overhead makes them lose money) instead of better.  The FDIC doesn’t want this to happen.  Hard caps may not be the best way to go about doing that, however.  Is 75 basis points, the difference a savings interest rate of 1.00% and 1.75% enough to convince you to move you money?  Of course, the interest is slightly better.  However, will you make the time investment necessary to make the switch?  This is an important consideration.

FDIC Trust Fund Capitalization Ratio, Through Q4 2008 (Source: FDIC)

A hard limit also hurts savers (although since savers pay taxes, it indirectly helps them by keeping the FDIC solvent…).  “Non-problem” banks merely have to increase their rates to 76 basis points above the average savings rate to take the capital that might flow to the problem banks.  This allows banks which are considered properly capitalized now have the capitalization advantage over banks that need to increase reserves.  This limits rate competition to around that magic 75 basis point range.  In practice, it will be interesting to see haw it plays out, but a Market Rates Insight report estimates that the average savings rate will drop 12 basis points as a result of this statute.

Remember the term ‘Moral Hazard‘?  It refers to a situation where a population insulated from a certain risk ends up taking more risk.  Since the FDIC insures our savings account funds, we don’t have to worry about the solvency of our bank.  Rate chasing is a viable option.  If we had to assume the risk of loss of our savings, we would probably invest in savings accounts similar to how stock investing is done- with large amounts of research into the financial health of our banks, and a good deal of diversification.  So, conceptually, we need a way to limit the amount of risk banks take on as a result of the incentives agents (savers) respond to.  Is a hard cap the best way?  I want to hear your thoughts!

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