The Federal Deposit Insurance Corporation is trying to do its part to respond to the crisis. It has proposed to change how it charges large financial institutions for depository insurance. The FDIC wants additional measures of risk to dictate its assessments on institutions over $10 billion in size. That sounds sensible. But why limit the change to big banks?
Small Banks Can Take On Big Risk Too
Here's what the press release says will change:
Under the proposal, risk categories and long-term debt ratings would no longer be used. The FDIC would continue to use the supervisory ratings as a factor in measuring risk. The FDIC would replace the financial ratios currently used with a scorecard consisting of well-defined financial measures that are more forward looking and better suited for large institutions. The proposal also includes questions about how to incorporate other risk measures, like the quality of underwriting or risk management practices, in the future.
These changes make a lot of sense. Debt rating was an aspect of finance found to be deeply flawed during the financial crisis, both for bonds and firms. Regulator risk categories had some problems too. A broader set of variables used to evaluate riskiness would force more aggressive firms to pay more for their insurance. Think of it like auto insurance: aggressive drivers often end up paying higher premiums than cautious drivers. Since there are many ways by which a firm can engage in risky behavior, there should be a number of variables taken into account, as the FDIC indicates.
Yet, this doesn't only go for large institutions -- why not apply the same standard to small banks? For example, if a regional bank in Florida had become heavily involved in subprime lending and engaged in very lax underwriting standards during the housing bubble, then shouldn't it have paid more to the FDIC for depository protection? The savings and loan crisis demonstrated that lots of little bank failures can add up.
Moreover, mostly smaller and mid-size banks failed. Only a few large depository institutions went bust during the crisis, and most of those were ultimately acquired. Obviously, the cost of unwinding bigger firms is greater, but so is their relative premium based on their larger depository base. So why does the FDIC seek to only penalize big banks here?
Today's proposed rule change seeks to put pressure on large banks to behave more prudently. If they don't, they'll have an added cost for their depository insurance. The goal is a safer industry, both through changes in risk appetite and additional cushion in the FDIC's depository fund to cover failures.
This all sounds great. But again, it's unclear why across-the-board changes aren't sought. Directing bank strategy away from aggressive behavior would also be a positive change for smaller institutions. The FDIC should not worry disproportionately about risky behavior on the part of big banks. The loss its resolution fund faces from a hundred banks of $5 billion in assets failing should be similar to that of one firm of $500 billion in size.
The FDIC is right to put additional emphasis on how bank risk is considered to determine depository insurance premiums. But it's perplexing why the regulator only thinks risk-taking matters for large banks. This rule change would create a system where large banks are penalized for aggressive risk taking while small banks are not.
Gross Assessments Won't Rise?
The press release also said:
The proposal also would alter the assessment rates applicable to all insured depository institutions to ensure that the revenue collected under the proposed assessment system would approximately equal that under the existing assessment system. Chairman Bair said, "By better differentiating risk among large institutions, the proposal would reduce insurance assessments paid by lower-risk institutions--both large and small."
The massive wave of bank failures following the crisis has caused some headaches for the FDIC. This was documented in a nice chart in this month's edition of The Atlantic. Its fund used to wind down institutions and pay out customers got so low that it forced a prepayment of bank assessments through 2012 to ensure it had enough cash to cover claims. That move implies that it didn't assess firms enough prior to the crisis. So why wouldn't the FDIC want to collect higher gross premiums going forward? The crisis proved that its fund's size wasn't sufficient to guard against severe financial turmoil.