One commonly hears the argument that the FDIC creates moral hazard in the banking system, because depositors aren't worried about the soundness of their banks. I find this argument broadly dubious, since I have no idea how the vast majority of depositors could possibly be expected to have informed opinions on the soundness of their banks. Moreover, during the Great Depression, local wealthy people--who did have quite a lot of knowledge about the banks, and the local economies into which they lent--got hammered along with the rest of America.
But this suggests that there is a different, more plausible form of moral hazard operating right now:
"A California Banker" writes to Mish, giving yet another reason why banks aren't lending:
If you're a bank with a relatively healthy balance sheet with adequate capital, (like us)you want to maintain surplus capital in order to stay on the FDIC's list of banks they can transfer the loans and deposits from a failed institution into.
This is a home run for the acquiring bank and far more of an instant benefit than any new lending.
The problem here is that healthy banks end up competing with each other to have the largest capital surplus and therefore the greatest chance of being anointed in this manner by the FDIC. If everybody was lending, the FDIC would still have to place failed banks' assets and deposits with someone. But instead we get the opposite corner solution, where nobody is lending -- except, presumably, for banks which are close to failure and need all the interest income they can get. I wonder whether the FDIC has anybody thinking about how to counteract this syndrome.
The FDIC system of liquidating banks by selling their assets to other banks seems to be fostering credit contraction. On the other hand, so does letting a bunch of banks fail.
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