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The relationship between FDIC insurance, large banks, and the concept of “Too Big To Fail” (TBTF) is one of the more troubling aspects of our financial system.  What most people don’t understand is that FDIC insurance is one of the primary drivers behind this TBTF concept.  FDIC undermines market forces in regards to risk management and subsidizes the large banks as a result.

Some have advocated eliminating FDIC to fix this issue, but I also see that as somewhat undesirable and difficult to implement. It’s true that consumers would help keep banks a bit more accountable in a completely unregulated system, but here’s the thing: I have analyzed banks for a living. If I’m not an “expert”, I’m at least more knowledgeable than 99.9% of the population. And it’s very difficult for me to say with a high degree of certainty which banks are safe and which ones aren’t in a crisis setting.

I can look at capital ratios, past loan performance, and other financial metrics, but all of that is “past performance” and none of that tells me if the bank recently lent out to a massive number of non-creditworthy customers . And if I’m better than 99.9% of the population at assessing this and I can’t even give you a good answer, than how does the other 99.9% fare?  This is simply an issue that requires a lot of expertise and your average depositor lacks that.

So deposit insurance, minimal capital ratios, and some sort of basic ground rules seem vital to me, in order to ensure the soundness of the banking system. But that doesn’t mean that our current system totally works.  While I’d hold the American banking system high above almost all the systems of Europe and much of Asia, as well, it still has some significant issues.  And we’re moving in the wrong direction right now.

The primary Congressional response to the financial crisis was Dodd-Frank.  Unfortunately, Dodd-Frank is a complete disaster and actually makes the TBTF issue worse, not better. It also makes small banks less competitive, which is precisely the opposite result a free market would yield.  More importantly, it’s this sort of result that puts the taxpayers in greater danger.

If I had my druthers, I think I’d go a much different way with banking reform. I would radically change the nature of FDIC. Instead of being a direct insurer, the FDIC should instead require the banks to purchase deposit insurance from a *private* insurer.

Why would this system be superior? For one, part of my thesis on why FDIC distorts the market is because the insurance rates don’t take into account the concept of systemic risk. We treat a small community bank and a giant mega-bank such as Citi or BofA as exactly the same under the current regulations. This is a competitive advantage for the mega-banks, because they create much higher risk, yet aren’t required to pay higher prices to reflect this risk.  In essence, they are being subsidized by the Federal government via the FDIC program.

Of course, there are other issues with the FDIC, as well.  As we’ve seen over the past few years, the nature of the failed bank sales ends up relying, at least in part, on political connections.  For that matter, we’ve seen that political relationships often end up being important to how the FDIC treats a bank.  All in all, there are a lot of issues with FDIC that the general public simply does not see.

If you shift the market over to private deposit insurance, the private insurers are going to be much pickier about the rates they charge and the risks they take on.  They are also going to be pickier about how they wind down a bank and sell off its assets.  It’s also going to make it very difficult for Citi and BofA to insure their own deposits. They might have to contract out several insurance companies and it’s likely that it’s going to be somewhat costly and force them to become more accountable to market forces.

There are some kinks to work out in this proposal, but I definitely view the moral hazard created by the FDIC’s subsidies as one of the primary reasons we have this TBTF problem. We have to restore market forces in deposit insurance or this moral hazard will continue.