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FDIC Woes Signal Larger Problem

This article is more than 10 years old.

Congress was told Thursday that the two government-sponsored mortgage enterprises (Fannie Mae and Freddie Mac) may need more public funds--but the Federal Deposit Insurance Corporation (FDIC) insists it can do without taxpayer dollars.

FDIC is best known for insuring individual depositors' accounts up to $250,000; however, it also plays a vital role in helping to reorganize, and dispose of, insolvent insured banks. Since the beginning of the financial crisis it has rescued 95 banks--with more in train--running down its reserves to a near record low.

There is no danger of the FDIC collapsing: It can raise funds either by increasing the premiums it charges banks on deposits (either immediately or on a deferred basis) or directly from the Treasury. However, its current difficulties highlight how distressed the U.S. banking system remains--which in turn explains why, despite unprecedented monetary loosening, credit is still relatively tight.

Remedial measures. To shore up its reserves without drawing on either Treasury funding or potentially pushing more banks into insolvency by increasing its deposit premiums, FDIC will execute an accounting maneuver. This involves extracting premium "pre-payments" from insured banks, while allowing them to refrain from booking these charges to their balance sheets until 2012. However, increased premiums are likely to hurt the medium-term outlook for bank profits. The annual fees paid by banks to the FDIC have increased steadily, with well-capitalized institutions now paying 12-16 cents per $100 in deposits, a figure set to increase by 3 cents from 2011.

S&L crisis experience. The FDIC has faced sudden demands on its reserves in the past:

--RTC scheme. During the S&L crisis from 1986 to 1995, 1,043 thrifts failed with total assets of $500 billion; the Federal Savings and Loan Insurance Corporation (FSLIC) became insolvent and was dissolved, leaving FDIC responsible for covering depositors' accounts. The creation of the Resolution Trust Corporation (RTC) in 1989, under the FDIC, helped to support the process of valuing and disposing of impaired assets by placing them into 'pools' injected with taxpayer funds, where private investors could buy-in (at a significant discount).

--PPIP prospects. Although the S&L crisis eventually cost taxpayers approximately $125 billion, by attracting private capital the RTC reduced this liability. Treasury Secretary Timothy Geithner is now attempting to emulate this approach to removing impaired assets from bank balance sheets through the Public-Private Investment Program (PPIP).

The PPIP has been slow to get off the ground, in part because, unlike the RTC, it involves purchasing assets from weak but not actually insolvent banks--which may be reluctant to dispose of assets that they believe will eventually recover, or value assets for sale that may require them to write down similar instruments. However, the Treasury has now rounded up an initial group of private investors; with government matching funds, they will purchase approximately $15 billion in impaired assets by the end of this month.

Outlook. The FDIC's role in helping to resolve the current financial crisis and recent move to bolster its reserves has three key implications:

--Banking industry outlook. The danger of another collapse by a major financial institution, and attendant systemic risk, is falling--in part due to the government's March 'stress tests.' However, the outlook for smaller banks remains gloomy and more failures appear inevitable.

--Pre-funding advantages. The pre-funded nature of FDIC deposit insurance provided a buffer that significantly reduced the cost to taxpayers of the financial industry tailspin. Congressional authorization for TARP was exceptionally difficult due to the political unpopularity of rescuing the industry from its own mistakes. FDIC reduced the size of the bill to the public, by extracting funds from the banks themselves. Absent sufficient pre-funding, the state must guarantee deposits directly, increasing the fiscal strain--as was the case in the United Kingdom.

--Reserve increase? When the crisis is over, FDIC may consider permanently increasing its reserves, further reducing the profitability of the sector--which already faces a long period of retrenchment.

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