Executive Summary
This report focused on the purposes, effects, and prospects for the Federal Deposit Insurance Corporation (FDIC). It shows that the FDIC led to a stable banking industry until 1980s. While opponents want FDIC eliminated because of several bank failures, this report established the agency should be reformed instead to prevent bank runs effectively while focusing on controlling TBTF and implementation of the Dodd-Frank Act.
The Purpose of the Case and Problem Statement
The FDIC has insured bank deposit in the US since the period of the Great depression. As such, some critics contend that the organization has become irrelevant in the modern baking environment. On the other hand, some observers believe that the FDIC should stay and increase its mission and activities.
It is believed that the banking industry will be more stable without the FDIC because the institutions would be more responsible with after the elimination of the security cover. This view therefore stresses that banks no longer focus on due diligence of their customers or depositors because of the presence of the FDIC.
On the other hand, it is observed that the FDIC should expand its mission, and the government should eliminate the $250,000 limit placed on the FDIC insurance to allow high net worth and large corporations to insure their deposits.
These two opposing views lead to a critical issue of which way forward for the FDIC. The purpose of this report is therefore to explore purposes, effects, and prospects for the Federal Deposit Insurance Corporation (FDIC).
Background information
Economic meltdown that led to the formation of the FDIC
Banks failure in the US has been a recurrent phenomenon since the first bank failed in 1809. The highest number of bank failure was witnessed during the Great Depression, which hit the US in 1929 and lasted until 1939. During this global economic downturn, thousands of banks in the US collapsed creating panic among depositors (Federal Deposit Insurance Corporation 1)
During the Great Depression, there were heated deliberations on federal deposit insurance to shield depositors from losses. The Congress, however, was initially occupied with resolving issues related to agricultural meltdown. Consequently, legislation on federal deposit insurance was delayed with only eight states having established deposit insurance funds policies after 1907.
However, the congress made a number of regulations on banking, especially from 1930, which include Hawley-Smoot Tariff Act of 1930, Reconstruction Finance Corporation (RFC) Act of 1932, and Federal Home Loan Bank Act of 1932. Nonetheless, the legislation did not thwart the depression immediately but the situation got worse (Federal Deposit Insurance Corporation).
Between 1932 and 1933, for instance, the US economy was adversely hit by the depression leading to 25% unemployment, national income going below 50% relative to 1929, and the stock market going below by 75% of 1929. At this stage, investors were willing to incur losses only if their money was safe. As a result, the treasury bills went negative. The deteriorating economic situation prompted the Senate Banking Committee to carry out investigations on the triggers of the Great Depression.
In 1933, the presidency of Franklin D. Roosevelt saw somewhat radical interventions including declaring a banking holiday on March 6, 1933. There was a further fall of about 4,000 banks and 1,700 S&Ls. More legislations including Emergency Banking Act of 1933 and The Securities Act of 1933 were enacted.
The creation of the FDIC (the Banking Act of 1933)
The Great Depression period led to bank failures that consequently led to depositors losing approximately $1.3 billion. Bank failures could otherwise be avoided if there was a mechanism in place to shield the banks from large-scale cash demands and fearful depositors. Thus, the Congress put in place legislation on deposit insurance by drafting the Banking Act of 1933 (Federal Deposit Insurance Corporation 1). The Act was signed into law on June 16, 1933, by the then US President Franklin Roosevelt. The essence of the Banking Act of 1933 was to promote confidence of the citizens in the banking system. Precisely, the Act was to address economic disruptions associated with bank failures and bank runs.
The initial purposes of the Act included establishing the FDIC as an impermanent government corporation to provide deposits insurance to banks, giving the FDIC the regulatory and supervisory power over all banks (including nonmembers) in the US, offering the FDIC preliminary funds amounting to $289 million in loan through the US Treasury.
Further, the Banking Act of 1933 extended the federal oversight authority to all commercial banks in the US and put a clear distinction between commercial banking and investment banking with the reinforcement of the Glass-Steagall Act. Additionally, the Banking Act of 1933 forbade the checking accounts method previously practiced by banks in the payment of interest and permitted all national banks to branch within the states but with the permission of state laws.
Nonetheless, the establishment of the FDIC did not alleviate the falling of banks as more insured banks fell in 1934. As a result, more regulations were put in place, including the Banking Act of 1935. The Banking Act of 1935 recognized the FDIC as a permanent federal agency. The trend of FDIC-insured bank failure, however, continued especially in the 1937-1938 recession.
The 2008 financial crisis led to the insolvency of some banks like the Washington Mutual (Federal Deposit Insurance Corporation). As a result, the FDIC was prompted to take over some of them while the government bailed out the rest like the wavering Citigroup and Bank of America (Federal Deposit Insurance Corporation 1).
The year 2010 saw the failure of 157 banks with $92 billion in assets, consequently, FDIC adopted radicle measures that led to the taking over of three banks in Puerto Rico costing FDIC $5.3 billion. The number of troubled banks rose to 775 having $431 billion in assets and, therefore, the FDIC reserve went to negative $20 billion, $19 billion in the Treasury and a $30 billion credit (Federal Deposit Insurance Corporation).
Achievements and effects of FDIC
The effect of the FDIC in the US banking industry has been immense since its inception in the early 1930s. First, the FDIC relatively managed to retain depositors’ confidence in the banking industry even through the many global and national economic meltdowns. The FDIC insures more than $7 trillion of deposits making it among the best performing federal agencies (The University of Kansas).
Additionally, with a loan from the treasury, the sFDIC has been able to shield a number of banks from failure. The loan was paid back and currently the FDIC receives no appropriation from the Congress. As such, the agent meets it needs through the funding of insured premiums.
Nonetheless, the FDIC success has not been absolute since a number of FDIC-insured banks have failed over time.
Application of Theory
Decision theory or the rational choice theory is concerned with the study of preferences, and matters associated with making sensible choices. People from different professionalism have used the theory and proved to be a viable tool in decision-making.
Decision theory can be classified into three categories to include normative, descriptive, and prescriptive decision theories. The normative decision theory examines the choices of idyllic agents, who are impeccably rational and with immeasurable figuring power. A perfect example of the normative model is the expected utility theory. Precisely, the expected utility theory states that rational agents choose the action with the highest expected usefulness (Kunreuther, Meyer and Zeckhauser).
On the other hand, descriptive decision theory examines the decision of relatively non-ideal agents who lack infinite computing power. The prescriptive decision studies the possibility of non-ideal agents improving decision-making skills despite their imperfections (Kunreuther, Meyer and Zeckhauser).
The use of decision theory can help in the decision of whether the FDIC will be eliminated or expanded. Further, stakeholders can make use of the theory in an attempt to solve some of the recurrent problems in the banking industry like the problem of bank fai
Approach and Methodology
A systematic review of existing databases was conducted to identify the most suitable resources for the study. It involved a collection and analysis of several studies on the FDIC. In this report, a critical approach has been adopted to examine a wide range of research evidence on the FDIC and the banking industry. Specifically, explicit and transparent literature from scholars and authorities were considered. Through systematic reviews, the focus was on finding as much as possible literature relevant to the FDIC, its practices, achievements, challenges, and prospects. In addition, an explicit approach was adopted to determine what could be reliably included in the FDIC report based on the contents of the available studies. The methods adopted to review the literature were not only explicit, but also equally systematic to create a diverse and reliable report. The review further focused on synthesizing study results in this report in easily accessible manner to the intended audience for this report. By adopting this approach, the systematic review applied therefore accounted for vital sources while reducing possible bias, which could have taken place during the review of various databases for the report.
Report Findings
As noted earlier, deposit insurance has existed for several years based on the current form model implemented initially in the US in the 1930s. Several financial crises, including the recent 2008-2009 recession, critically exposed the major flaws in the entire banking system globally (Wesemann 10). These financial crises have shown that the banking system relies on poorly supported equity capital to support rapid growth witnessed in the last four decades.
The Banking Industry Status
Latest data released by the FDIC have shown that the US banking industry has continued to recover from the effects of the last financial crisis gradually. The gradual albeit steady recovery is related to economic recovery and increments in the rates of employment, interest rates, and consumer spending power.
However, it is imperative to point out that the economic growth, now approaching the third year, has been characterized by elements of distress and downturns specifically in the real estate sector alongside a poor, painful trend of expenditure control among households, small businesses, financial service providers and even federal, state, and local governments. As such, the result has been disappointing. It is, for instance, noted that the current recovery rate is sub-par relative to recoveries following the past economic recoveries after depression and recessions. Moreover, it is characterized by constant uncertainty with regard to the future economic, job, and the banking industry prospects (Gruenberg 1).
All these elements of uncertainties are, of course, present critical challenges to the government and other policymakers, as well as the public. The FDIC specifically must stay alert to all these issues.
It is also imperative to note the positive trends in the banking industry. Data from the FDIC has shown overall improvements in the status of the insured financial services providers. The industry has also recorded growths in revenues and earnings in the past two years. The FDIC has recorded a decline in the percentage of noncurrent loans from the insured financial institutions. This observation shows that the banking industry overall credit quality has improved. Further, troubled banks recorded positive growth after five years for the first while the Deposit Insurance Fund noted positive trends and the FDIC has forecasted lesser failing financial institutions in the coming years.
As such, the FDIC-insured financial organizations are better placed to manage the current uncertainties in the market. It is also observed that the financial industry has restored its capital ratios to significantly higher levels. Hence, there is adequate capital cushion that can cater for further loan losses if they occur and support new lending opportunities as consumer loan demands increase.
Banks have however focused on enhanced loan-loss provisions to target the historic norms, which have resulted in positive earnings within the financial industry. It is expected that banks will increase their lending as a means to grow their revenues (Gruenberg 1).
Calls to Eliminate the FDIC
Critics of the FDIC assert that the institution has outlived its useful because it was only meant to be a temporary solution for post-Depression financial challenges. Today, however, more than $7 trillion has been identified as bank liabilities attributed to the role of the FDIC. As such, there is no due diligence of depositors. Without considering the Wall Street, hundreds of banks have collapsed because of excessive risks they took. Further, the FDIC did not take about such practices. This implies that most of these banks fail because of the FDIC that provides deposit insurance. The government bears the risk while the banks earn huge returns (Cass 1).
Therefore, eliminating the moral hazard and being too big to fail implies that the FDIC must go in the process. These failures reflect problems with the current FDIC systems.
Since 1980s, scholars such as Loretta J. Mester had pointed out the problems with the FDIC (Mester 16). Despite the existence of the FDIC, it was noted that bank failures had increased while the challenges with the insurance funds had increased considerably. These issues exposed the challenges with the current FDIC system. It is observed that since its inception to 1980s, the FDIC functioned optimally. It had eliminated contagious bank runs while few bank failures were noted. After the 1980s, however, increased interest rate volatility, problems in the energy and agricultural sectors were severe, and fierce competition from non-depository institutions emerged (Mester 16). These problems led to increased failures among banks. As such, the deposit-insurance funds had a big burden leading to the insolvency of the Federal Savings and Loan Insurance Corporation in 1986.
The role of Bank Insurance Fund (BIF) also came under scrutiny following its operating losses. BIF was under the supervision of the FDIC. Consequently, depositors lost faith in the FDIC. Moreover, Ohio Deposit Guarantee Fund could not even bail out its depositors, leading to massive runs in the industry.
The major challenge within the system is the incentive. While it is generally acknowledged that risk-taking is important to spur economic progress, and banks are responsible for this activity by taking on risky ventures, the current deposit-insurance system of the FDIC has encouraged banks to take on more risks that are bad for the public. If the risk pays off, then the bank equity holders generally benefit from huge dividends. Still, they do not have to pay more for engaging in more risky behaviors. Moreover, insured depositors lack any incentive to ask for higher rate on deposits they put on riskier financial institutions. Usually in bigger banks, larger depositors, are not supposedly insured, do not ask for much of the risk premium because they generally do not experience any losses in the event of a bank failure. This is attributed to the FDIC practices on closing larger banks. The FDIC often settles for buyers who take all the liabilities of the bank, including insured and insured deposits. Alternatively, the FDIC creates direct loans these banks – leading to a cover for uninsured bank’s creditors.
In addition, the current system only requires banks to pay a flat rate fees for their insurance, irrespective of the riskier nature of their portfolios. Given the flat rate system, the FDIC should conduct thorough controls, execute regulations and carry enhanced assessments, but these approaches have generally been less effective.
Further, no player has demanded that banks should increase the rate for insurance for engaging in more risky practices. Thus, when a bank faces a turmoil and impending bankruptcy, there is a tendency for stakeholders to ‘inject more capital’ because they have everything to gain and little to lose. If bank’s riskier behaviors fail to pay off, then the deposit insurer absorbs the loss. As such, the challenges occasioned by the too-big-to-fail (TBTF) will persist so long as the FDIC is running (Stern 1; Nelson 22-25).
Given these systemic failures of banks and fundamental flaws in the current FDIC, the insurer should be reformed rather than disbanded.
Fixing the Bank Runs
The failure of the S&L exposed the weaknesses of the FDIC. Hence, to eliminate financial institution crises, bank runs should be averted and ensure stable banking industry. It is also possible to redefine the role of federal deposit insurance and reduce incentives it offers banks to engage in excessive riskier investments. Abolishing the FDIC will lead to other alternatives.
First, the Federal Reserve could take over the roles of the FDIC. In this arrangement, the Fed will bail out failed banks using their assets as collateral. However, critics argue that the Fed failed to avert the crisis of the 1930s, and it would be subsidizing excessive risk-taking.
Second, idea to introduce private insurance has gained traction. However, a private firm may lack the credibility provided by the government, may not have sufficient capital, and offer too little insurance.
Finally, the narrow bank approach focuses on restricting the kind of investments the bank can fund with the insured deposits to avert risks.
Reforming the FDIC
Depositor Reform
Depositor discipline would ensure that the insurance ceiling is adjusted (currently at $250,000). This involves lowering the ceiling for insured deposits to $10,000 or imposing a cover for a specific percentage of the deposit. This would ensure risk premium for deposits in riskier banks. Second, insure individual depositor’s single account rather than each account. Third, the FDIC must reform the TBTF.
Equity Holder and Non-depositor Reform
First, capital requirements involve higher equity requirements from equity holders while supporting low debt requirements.
Regulatory Reforms
These reforms should focus on risk-related premiums to discourage excessive risk taking, asset categorization into various risk classes, increased supervision, and rebate.
Conclusion and Summary
The FDI has a relatively long history. However, the failure of the S&L and the failure of the TBTF in 2008-09 crisis exposed its weaknesses. Consequently, critics want it eliminated. Conversely, proponents call for reforms of the FDIC to control bank runs. Given the role of the FDIC, this report promotes the need to reform the FDIC so that it can rein on TBTF and prevent bank runs. Besides, the FDIC should also concentrate on enhanced deposit insurance reforms, bank supervision, and bank resolution. It should further focus on its responsibilities as indicated under the Dodd-Frank Act. The above-mentioned reforms are most likely to curb bank runs and ensure a revamped FDIC.
Works Cited
Cass, Sam. Peter Atwater Suggests Eliminating FDIC as Part of Banking Reform. 2010. Web.
Federal Deposit Insurance Corporation. Federal Deposit Insurance Corporation. 2015. Web.
Gruenberg, Martin. Present and Future Challenges for the Banking Industry and the FDIC. 2011. Web.
Kunreuther, Howard, Robert Meyer, Richard Zeckhauser, Paul Slovic, Barry Schawartz, Christian Schade, Mary Frances Luce, Steven Lippman, David Krantz, Barbara Kahn and Robin Hogarth. “High Stakes Decision Making: Normative, Descriptive and Prescriptive Considerations.” Marketing Letters, 13.3 (2002): 259-268. Print.
Mester, Loretta J. “Curing Our Ailing Deposit-Insurance System.” Business Review (1990): 13-24. Print.
Nelson, Eric. “FDIC: The Longest Running Bailout of American Banks.” Elon Business Law Journal 1 (2015): 22-25. Print.
Stern, Gary H. Too Big to Fail: The Way Forward. 2008. Web.
The University of Kansas. Federal Deposit Insurance Corporation (FDIC). 2016. Web.
Wesemann, Andreas. The Abolition of Deposit Insurance: A modest proposal for banking reform. London: Centre for Policy Studies, 2016. Print.