The FDIC: Outdated Supervisor of Modern Banks

The FDIC: Outdated Supervisor of Modern Banks

The Evolution of the FDIC

90 years ago, in the wake of the Great Depression, the US government established the Federal Deposit Insurance Corporation (FDIC) to restore faith in the banking system. The FDIC was tasked with resolving failed banks and protecting depositors by guaranteeing their funds. This deposit insurance helped prevent bank runs and stabilize the financial system. However, as the banking industry has evolved and become more complex, the FDIC’s role and effectiveness have come into question.

Challenges of the Modern Banking System

In the modern age, banks no longer rely solely on demand deposits for funding. They have diversified their liabilities and rely on various forms of short-term funding, such as federal funds, repurchase agreements, and commercial paper. These non-deposit liabilities have grown significantly, reducing the effectiveness of deposit insurance in preventing bank runs.

The FDIC’s influence has also diminished over time. While it covered a large portion of the banking system in the mid-20th century, its coverage has dwindled to just 25% of commercial bank liabilities by 2008. The FDIC does not insure non-deposit liabilities and does not guarantee individual deposits beyond the insurance limit, leaving a significant portion of the banking system unprotected.

The FDIC’s Inability to Adapt

The FDIC’s outdated structure and limited powers have become apparent during times of financial crisis. In 2008, during the height of the financial crisis, the FDIC was faced with the task of resolving the failed bank Washington Mutual (WaMu). The FDIC was pressured to protect WaMu’s unsecured creditors, but its inability to do so contributed to the collapse of Wachovia, the fourth-largest US bank at the time.

This inability to adequately protect the banking system during times of crisis highlights the need for the FDIC to be reimagined and reorganized. The FDIC must be capable of resolving large, complex, and interconnected banks, as well as protecting the entire financial system.

A Potential Solution: The Pawnbroker for All Seasons

One proposed solution is Lord Mervyn King’s Pawnbroker for All Seasons (PFAS). This alternative financial system merges the functions of the central bank and the deposit insurer. Under the PFAS, the central bank would insure the liquidity of all short-term liabilities by requiring banks to preposition collateral sufficient for their short-term funding needs.

The PFAS would not only act as a lender of last resort in times of crisis but also lend to banks in good times based on their risk-weighted asset level. This approach would significantly reduce the need for extensive supervision, as the insurance itself would mitigate risks.

However, implementing such a system comes with challenges. Estimating the appropriate haircuts for collateral and maintaining the independence of the regulator could prove difficult. The efficacy of the PFAS is also uncertain, as it has never been tried before.

The Need for Reform

Regardless of the specific solution, it is clear that the FDIC’s current structure is outdated. Nontraditional bank liabilities and the growth of the banking system have exposed the limitations of the FDIC’s powers. The FDIC’s coverage has decreased, making the banking system more fragile and susceptible to runs.

Reforming the FDIC and merging it with the Federal Reserve, which primarily supervises credit markets, may be a viable solution. The consolidation of these regulators would align their areas of responsibility and ensure a more comprehensive and effective approach to protecting the banking system.

Frequently Asked Questions

1. What is the FDIC?
The FDIC, or Federal Deposit Insurance Corporation, is an independent federal agency that provides deposit insurance to depositors in US banks and savings associations. It was established in 1933 to help restore confidence in the banking system during the Great Depression.

2. How does the FDIC protect depositors?
The FDIC protects depositors by providing deposit insurance. It guarantees deposits of up to $250,000 per depositor, per insured bank. This means that even if a bank fails, depositors will still receive their insured funds.

3. Why is the FDIC considered outdated?
The FDIC’s structure and powers were designed for a different era of banking. The growth of non-deposit liabilities and the complexity of modern banks have exposed the limitations of the FDIC’s coverage. It is now unable to adequately protect the entire banking system during times of crisis.

4. What is the Pawnbroker for All Seasons?
The Pawnbroker for All Seasons (PFAS) is a proposed alternative financial system that merges the functions of the central bank and the deposit insurer. It aims to provide comprehensive insurance for short-term bank liabilities and reduce the need for extensive supervision.

5. How can the FDIC be reformed?
Reforming the FDIC could involve restructuring its powers and responsibilities, as well as merging it with other regulatory bodies such as the Federal Reserve. This consolidation would create a more cohesive and effective approach to safeguarding the financial system.