Yesterday’s missile from John Mauldin [1] delivered another dose of concern with how the banking system will face its present challenges. In particular, he is worried about whether the FDIC will be strong enough to cover losses to all the bank deposits it insures. At the same time the WSJ posted a report [2] celebrating new ways that an individual investor can optain FDIC insurance on millions of dollars of CDs bought at one institution. Those two stories taken together sound like the scenario where an irresistable force meets an immovable object.

So what’s going on? If I understand this 2005 academic paper [3] that touches on the issue, the Gramm-Leach-Bliley Financial Services Modernization Act (1999) opened the way for a variety of innovative new strategies in financial services, including schemes like the The Synovus® Shared CD program, where a bank holding company automagically splits a retail customer’s CD that’s over the $100,000 FDIC insurance limit into a number of "segments" under $100k and held by a number of affiliated institutions.

Shortly after GLB was enacted, AEI’s Peter Wallison took the opportunity of a speech at the Chicago Fed [4] to celebrate this new era of banking self-regulation.

More recently, the concept of CD splitting has been democracized to independent banks, who have joined into registries that pass CD segments among the group. CDARS is a large, growing, and perhaps dominant player in this space. "CDARS® is the Certificate of Deposit Account Registry Service®. And it’s the most convenient way to enjoy full FDIC insurance on deposits of up to $50 million." Like, wow. Their sales pitch at this page (use the "click here" at the right to see the promotional video) is slick and very compelling.

CDARS’ reach lets retail savers from Lebanon, NH to Anchorage, AK blow past the FDIC $100k limit like it wasn’t even there. Since deposit insurance is, after all, insurance, I’m guessing that one motivation for the limit was to help protect the Corporation against adverse selection. As savers start to pile into (over $100k) deposit insurance because they foresee there could be difficulties with certain banks, FDIC could well be seeing more insured deposits than they had modeled for pre-GLB at the banks they might have to shut down over the next while.

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Notes and References

[1]: "Banking Systemic Crisis as Losses Pass $500 Billion", by John Mauldin, Market Oracle, August 23, 2008.

Yet another crisis confronts us, as we will have to deal with the aftermath of a rather large number of bank failures over the next year, which is likely to overwhelm the ability of the FDIC to insure your bank deposits. Today we look at the banking system, the FDIC, and Freddie and Fannie. It’s not pretty, but as realists we must know what we are facing.

 

[2]: "Banks Spread Deposits, and Risks: Multibank System Meets FDIC Limit, But Rates Are Lower", by Shelly Banjo, Wall Street Journal, August 23, 2008.

Edna Turner isn’t concerned about getting high returns on her savings accounts and certificates of deposit. The 89-year-old Ms. Turner wants to keep her money "safe for future generations," she said.
…

Ms. Turner opted for Columbus, Ga.-based Synovus Financial Corp.’s Synovus Bank Shared CD program. It offers customers up to $3.5 million in FDIC-insured CDs by spreading deposits in CDs across 35 Synovus network banks, as if they went to each bank individually and opened a CD.
…

After recent bank failures and other turmoil in the financial industry, Ms. Turner said, "I can just sit back and relax and know my money is safe."
…

There are other ways to increase insurance protection. Many banks have joined a program called the Certificate of Deposit Account Registry Service, or Cdars, which can protect customer deposits up to $50 million with FDIC insurance. Of 2,274 banks in the program, 330 joined or are in the process of joining since July 1.

 

[3]: "Deposit Insurance, Bank Regulation, and Financial System Risks", by George Pennacchi, draft prepared for Carnegie-Rochester Conference Series on Public Policy, April 15-16, 2005. was later published in Journal of Monetary Economics, Volume 53, Issue 1, January 2006, Pages 1-30.

Access to free deposit insurance was made easier by the “Gramm-Leach-Bliley” (GLB) Financial Modernization Act of 1999 which allowed banks, securities firms, and insurance companies to affiliate under a financial holding company.18 An important example of this is the recent trend by securities brokers to shift their customers’ “sweep” account balances from money market mutual funds into FDIC-insured bank deposits.19 …
…

… It is not surprising that a zero price has increased the attractiveness of deposit insurance. While the banking industry has thus far been unsuccessful in obtaining legislation that would raise the deposit insurance ceiling of $100,000 per depositor per bank, financial innovations have allowed banks to skirt this restriction. If, as is increasingly the case, a bank is a member of a multi-bank holding company, it may allocate large deposits in below $100,000 segments between other member banks to achieve full insurance. A similar service for independent banks was established in 2003 by Promontory Interfinancial Network.17 Their Certificate of Deposit Account Registry Service (CDARS) allows a bank that joins this network to swap chunks of below $100,000 deposits with other banks in the network. Currently over 700 banks have joined the CDARS program, and Promontory advertises that it allows a bank to achieve FDIC insurance on deposits of up to $10 million.

17 Promontory is a bank consulting firm led by former Comptroller of the Currency Eugene Ludwig and former vice chairman of the Federal Reserve Board of Governors Alan Blinder.

 

[4]: "The Gramm-Leach-Bliley Act Eliminated the Separation of Banking and Commerce: How This Will Affect the Future of the Safety Net", by Peter Wallison, speech, Chicago Fed, May 5, 2000.

FDICIA, accordingly, was the first step in eliminating the government safety net. It will not be the last chapter in the deposit insurance saga. For the reasons stated, the deposit insurance system is highly unstable. Healthy banks bear responsibility for the bad management of weak ones, but have no way to control or discipline them. The FDIC, which has the power to control and discipline, bears no responsibility for the losses. This will have to change. At some point, after there have been more losses of the kind we have seen this year, the banking industry will attempt to take over the administration of the deposit insurance fund.
…

… if Congress follows out the implications of the GLB Act, the elements of the so-called safety net will not be difficult to displace.

The deposit insurance system has already been privatized—in the sense that the government is no longer at risk for its losses. It only remains to turn its administration over to the banking industry.
…

If this analysis is correct, the safety net—as it was understood at the end of the 20th century—will wither away in the 21st. Along with it will go the policy reasons for intensive regulation of banks. Ultimately, this change will come about because of a recognition in Congress that banks are no longer special and unique financial institutions. When future scholars look for the roots of this conclusion, they will find them in the Congressional judgment concerning the uniqueness of banks that underlay both the Gramm-Leach-Bliley Act of 1999 and its elimination of the separation of banking and commerce.