02 July 2010

Time to Get Rid of Deposit Insurance

Want to fix safety and soundness concerns at credit unions? Want to make member ownership and the democratic process mean more at credit unions? Eliminate the NCUSIF.

Seriously, get rid of it. Get rid of the FDIC Deposit Insurance Fund (DIF) as well.

I realize this cannot (will not) happen, but it needs to. Here's why:

1) We need an environment of healthy risk. Our regulators are charged with maintaining the health of deposit/share insurance fund pools. Their goal is to minimize risk. But while too much risk is clearly not healthy, zero risk is a problem as well. A financial system that allows for zero risk doesn't help entrepreneurs get ideas off of the ground, doesn't help borrowers that need help the most, and doesn't allow the flexibility necessary to adapt quickly enough to changes in consumer need.

"Dude... Haven't you read about that thing they call the Great Depression?" you're likely wondering. "How about all of the bank and credit union failures in the past couple of years? Consumers need protection."

You're right. There were many lessons to be learned from the Great Depression. The most important one, of course, was that we have an obligation to make sure consumers and investors are provided with reliable information about the financial institutions they do business with. Deposit insurance doesn't improve the reliability or transparency of information, it makes information irrelevant. That brings me to the second reason we need to abolish deposit insurance.

2. Deposit insurance doesn't protect consumers, it harms them. Deposit insurance puts consumers at risk, even if indirectly. It's expensive. Although credit union members have never lost a dime of their insured funds in the history of the NCUSIF, and no taxpayer dollars have ever been used into the fund, its administration and the opportunity cost of maintaining a $20 billion organization (and keeping $10 billion in liquidity from consumers) is significant.

The story is worse for the FDIC's fund. Underwater by $21 billion, and losing on average nearly $2.8 billion/month due to bank closings since July 2008, the FDIC DIF has seen better days. Unfortunately, these aren't simply paper losses.

Where does this money come from? (After all, it is a zero sum game.) Recapitalization of these funds requires some combination of increased money supply (Treasury prints more money), taxpayer funded bailouts, and special assessments charged to financial institutions. The result is a vicious circle of some combination of higher taxes, more expensive financial services, more bank/CU closures, more consolidation (less consumer choice), and inflation.

"Great. So what you're saying is if a depositor's financial institution goes under, it's OK that they lose their life savings?"

Well...yes. That sounds awful, but let me explain with my third reason we should abolish deposit/share insurance.

3. The deposit/share insurance safety net discourages consumer due diligence. You know why people deposit funds at risky financial institutions? It doesn't matter if the bank/credit union fails. Their deposits/shares are covered. What if they weren't? Consumers would be forced to scrutinize the institutions they choose to do business with, be more skeptical of "too good to be true" offers, and take more ownership of their financial decisions (who they bank with, which products they choose, etc.).

The financial literacy crisis in America has been exacerbated by an almost ever-present consumer safety net. Want businesses, consumers, and government to be more cautious with risk? Let them fail. The reality of a poor decision's painful consequences is a great teacher.

"But how do you prevent a potential 'run on the bank'? Sounds like you are begging for the entire system to fail."

Actually, I'm begging for a much less intertwined system. That brings me to my last point.

4. Cooperation and insurance coverage should be opt-in and fair. Unlike in the banking world, where riskier institutions pay a higher premium to the DIF than more conservative banks, the NCUA makes no distinction between the funding requirements for risky credit unions versus more conservative credit unions. What does that mean? It means that conservative credit unions get punished for being responsible stewards of their members' assets, while credit unions that pose a much larger threat to the NCUSIF are not required to compensate for that risk. Risky credit unions do all the drinking and dancing, then ask the designated drivers to split the bill with them. Not cool.

Banks and credit unions should be given the choice to offer insurance or not. Further, they should be allowed to collaborate with any other financial institution or third party to form their own insurance funds with like-minded organizations. Some consumers will refuse to do business with a financial institution that doesn't offer deposit insurance. That's cool. The market will adjust. Some consumers will decide that higher returns, convenience, and innovation are worth a little bit of risk on their end. That's cool, too.

Government should demand financial institution transparency, send financial institution employees to jail for any deposit losses, and let consumers dictate what system develops. The system that crashed in 2008 rewarded ignorance, encouraged unnecessary risk, and placed zero responsibility on consumers or financial institutions to manage the balance of risk and reward. The system I'm proposing is different.

Now that you all think I'm crazy. Let me suggest an alternative fix: reduce the cap on insured shares.

The move to permanently increase deposit insurance from $100,000 to $250,000 flies in the face of reason. If anything, we should reduce that number to $25,000-$50,000. That amount covers most of America. The wealthier segment of the population, then, would be left with three choices: 1) Deposit funds in multiple, diversified financial institutions; 2) Do business with only the most safe and sound financial institution(s); and/or 3) Find an alternative use for those funds.

The sooner we can move away from the ghosts of misunderstood Great Depression lessons, the sooner we can develop a system of personal responsibility, managed risk, and sustainable operations.

12 comments:

Ben said...

Matt -- I like John Galt as much as the next guy. But even with a college degree in hand, I am simply not capable of (nor inclined to) scrutinizing the books of every financial institution with an attractive offer.

I think there's plenty of risk available to those that seek it, but it's hard enough to get underserved folks to save anything. This might be a bridge too far.

Matt, the Credit Union Warrior said...

Ben - thanks for the comment! Ayn Rand appreciates the plug. :)

A bridge too far? Maybe. However, I'm not suggesting that consumers should have to scrutinize every aspect of every financial institution choice on the market. Rather, I'm talking about a marketplace in which: 1) If consumers are interested in deposit insurance, it's available (at a price); 2) the riskiest institutions and depositors don't force their conservative brethren to compensate for that risk; and 3) consumers/financial institutions are free to earn higher rewards at their own risk.

I'm not suggesting we get rid of our regulators. Perhaps their role could be a tranparent rating system (kind of like restaurant inspection scores in some states) that could be posted at the entrance of each financial institution. Super risky, moderately risky, neutral, conservative, super conservative...or whatever.

Ron Shevlin said...

Can't believe I'm going to say this...but....I disagree with Ben.

First off, we might not need to scrutinize the books for every FI. That's what rating agencies are for.

But, there's a growing # of people who make their own investment decisions. In effect, aren't they not just "scrutinizing the books" but forecasting/projecting the future value/worth of the stocks they're investing in?

If they can do that with the info available, why can't we as consumers do something a whole lot easier -- determine the short term riskiness of an FI we're considering putting our deposits in?

But Ben is probably right that it IS a bridge too far. Especially these days, with the re-emergence of Big Daddy government to watch over us and make our decisions for us.

Gene Blishen said...

There are some points that need to be looked at and discussed if you go this route:
- the aspect of credit unions being joint and several. Some legislations have that a a core value.
- regulation required when you offer the ability to deposit funds in the public realm.
- risk rating for credit unions needs to be variable. If it isn't there is no incentive to change.
- the further inability of non-professionals to view financial statements of credit unions especially when they move from GAAP to IFRS.
- when people move money to higher rewards they at times are blind to the risk until it comes back to haunt them. Then they cry for the bailout. Just look at the recent bailouts.
- large versus small credit unions have very different appetites when it comes to growth and management of risk.

Matt, the Credit Union Warrior said...

@Ron - Thanks for your comment. I actually didn't expect anyone to agree with me... I think the "nanny state" we have created is precisely why this will never happen. I'm all for consumer protection, but we must limit its scope. Mandate open and honest information disclosure, and let consumers make their own decisions accordingly.

@Gene You're absolutely correct. I think that some credit unions will gravitate towards the current system even if it's not mandated. Others will see freedom from that system as a chance to make innovative leaps in service offerings. Others still will jump in and out of the system based on short term needs. The market will dictate which is desirable.

Also, I think you're 100% correct about the rating system and an easy-to-digest accounting system. Consumers shouldn't have to have a CPA or MBA to be qualified to pick a financial institution. Instead, come up with a system that calculates an FI's risk - A through F, expected value of a $1 deposit, 1 through 100, whatever you want. This is the information consumers need, not whether or not the institution is federally insured. As we've seen over and over again in the past few years, that doesn't ensure safety and soundness...just unnecessary expense.

Anthony Demangone said...

Matt,

An interesting post, but I do not think consumers have the tools to manage this level of information. (Not to mention, credit unions have gone from a CAMEL 1 to failure in less than a year. Fraud can bring a credit union down quickly.) Keep in mind that consumers lined up around the block to take money out of IndyMac bank, even after the FDIC told people that their money was insured. Without insurance, even safe organizations would be subject to runs based on rumor or speculation.

Matt, the Credit Union Warrior said...

@Anthony Thanks for your comment! You're 100% correct about speculation, rumors, and fraud. You're also correct about how quickly you can go from a CAMEL 1 to a kaput 1. A better rating system will fix the speculation and rumors problem. Without a trusted (and easily understood for the public) measure of institution risk (CAMEL doesn't cut the mustard), the impact of these forces will continue to be fierce.

As for fraud. There's not a whole lot of help there. That said, there is a legal system in place for that. Just as consumers can be lured into a Madoff type of "too good to be true" scenario, they can be sucked into any bad purchase or investment decision. Fraud is illegal. Make the punishment strict enough, and you'll eliminate most of it. Private insurance can take care of everything else.

Breathe said...

Late to the game, but I just had to say:
"That's what rating agencies are for? You have heard of a little thing called Mortgage Backed Securities and the Fabulous Job done by rating agencies?"

Frankly I'd never trust a rating agency on telling me what brand of nail file to buy, let alone whether or not my FI is triple A or not.

Face it - we can't even get consumers to take the step to switch when they know that a CU is a better deal. Thinking they will track ratings on FIs is not likely and will, in the end, only work with the highly educated and informed.

Which is not really conducive to a credit union mission, is it?

Matt, the Credit Union Warrior said...

@Winter Thanks for your comment! You bring up two interesting points: 1) Rating agencies don't have a great track record, and 2) Consumer apathy and financial illiteracy

My response is simple: 1) Yep, rating agencies don't have a great track record...either do our regulators in keeping the financial system safe. There's a heavy cost to both.

2) Consumers don't care because in way too many cases, they don't have to. A system that requires more personal responsibility will be one that sees more and more consumers flocking to credit unions.

Sarah Snell Cooke said...

Like you, Matt, but you're dead wrong. In theory, your idea isn't a bad one. I like Ayn Rand myself. In practice, it would just stink. Complaints rain down that credit unions don't do enough to help the underserved, many of whom are also undereducated, and now you want to take away deposit insurance? I don't have the time to monitor my institution's financials; I don't think I'm alone there. And I would wager that the vast majority of people wouldn't understand a balance sheet if you smacked them around with it (to your follow up comment "an easy-to-digest accounting system"--made me chuckle).

Your point on fraud is moot too. ("Fraud is illegal. Make the punishment strict enough, and you'll eliminate most of it.") You discount two points: Fraud is very, very difficult to detect, so I'm not sure you could scare fraudsters away from it; and 2) honestly, not all people who commit fraud are evil--they may be trying to pay for their parent's operation to keep them alive or to merely feed their children--they'd do it no matter the penalty.

"A better rating system will fix the speculation and rumors problem." I just don't even know what to say to that. Apparently many smart people thought the rating system we had was pretty good, and they will the next one too.

One point I think is sorely missing from this debate is the PR angle: how do you take away deposit insurance without riots in the streets? The loss in consumer confidence in the banking system would kill it. I understand you're trying to eliminate the moral hazard that's been debated since deposit insurance's inception, but even with a cooperative, risk-weighted system, flaws abound. Won't larger CUs flex their muscle when the insurer is making business decisions?
All that said, there's nothing I know of, other than a lot of hard work, keeping credit unions from starting a deposit insurance CUSO. Might be an interesting experiment.

Ben said...

I always think of new arguments about a week too late. The system you're suggesting already exists: It looks a lot like Lending Club, Prosper, and their ilk -- both of which have pretty transparent risk grading built in.

Now they're too young to compare with the established deposit system, but they still haven't uncovered deep wells of demand, despite the better rates available there. I think (and what I think is always supported by research somewhere) that most people like segregating deposits from investments, and this would mix them up in the popular perception.

Georgeh said...

Australia doesn't have deposit insurance. That's a good laboratory for seeing how things work.