The Federal Deposit Insurance Corporation (FDIC) is the U.S. agency responsible for insuring all bank deposits and facilitating all bank resolutions. Yet, as only one of three bank regulators, the agency relies on the Federal Reserve (Fed) and Office of the Comptroller of the Currency (OCC) to help perform those tasks as to banks the FDIC does not oversee. Moreover, the FDIC negotiates with the others on bank regulation to avoid regulatory arbitrage and may acquiesce to the preferences of another agency rather than act as it believes best (see, e.g., the Basel III Endgame rulemaking). Despite Congress’ intention that the FDIC be the agency responsible for preserving the Deposit Insurance Fund (DIF) and preventing taxpayer bailouts, these dynamics undermine that goal and put taxpayers and the economy at risk.

This need not be the case, as there are ways for the FDIC to assert itself without relying on the other banking regulators. In a new paper, I encourage the FDIC to use its authority to set deposit insurance rates to more accurately reflect the risks posed by banks, encouraging risk-mitigating changes that the Fed and OCC will not require.

The Constrained FDIC

The FDIC serves three primary functions but is significantly limited in performing them by its interactions with and reliance on the Fed and OCC.

First, the agency is the primary federal regulator for state banks that are not members of the Federal Reserve System (known as state non-member banks). However, it must negotiate policy with the OCC and the Fed (which regulate national and state-member banks, respectively) to avoid a regulatory race to the bottom. That banks may choose their regulator has led the banking agencies in the past to maintain different regulatory restrictions, resulting in a so-called “competition in laxity” that partially caused the last two financial crises. Regulators today have tried to maintain regulatory unanimity, but this may at times result in the FDIC’s adoption of policies less rigorous than it believes appropriate for its institutions.

Second, the FDIC insures depositors of insured depository institutions (IDIs) up to $250,000 per person per institution, which also gives the agency oversight of the DIF. Thanks to this responsibility, Congress has given the agency limited regulatory authority over national and state-member banks, but its associated enforcement authorities are cumbersome and rarely used. For example, although the FDIC may approve insurance applications that require IDIs to operate with heightened financial and operational standards, the FDIC’s enforcement is limited to terminating IDIs’ insured status – a blunt instrument the agency rarely uses, as it usually forces institutions into receivership. Accordingly, the FDIC relies heavily on the other regulators to prevent losses to the DIF by ensuring their institutions’ continued solvency.

Finally, the agency serves as conservator or receiver for failing or failed IDIs. But before it can do so for national and state-member banks, the OCC and Fed must appoint the FDIC to that role, and these regulators may have incentives that are not aligned with the FDIC’s. The OCC competes with states to charter institutions and receive fees, giving it an incentive to under-regulate, and the Fed’s role in setting monetary policy can cause it to turn a blind eye to activities the FDIC would deem risky, preferring instead that banks provide additional capital to the real economy. These regulators may delay placing banks into receivership and appointing the FDIC as receiver with the hope that more time will give flailing institutions chances to regain solvency, even though doing so may result in dissipated assets, increased costs to the DIF. and losses to uninsured depositors.

Regulation by Deposit Insurance

A solution to these constraints is the concept of “regulation by insurance,” in which insurers use underwriting standards, premiums, loss-sharing, loss-prevention services, well-designed contracts, and other tools to encourage policyholders to reduce risks in ways that regulation cannot – or regulators will not. Today, private liability insurers engage in regulation by insurance when they increase premiums for insureds who do not undertake certain remedial actions, decrease premiums for those who do, and exclude from coverage certain types of risks where policyholders do not first mitigate risks. Incentives to engage (or not engage) in named activities, rather than to generally limit risk, can be found in practically all types of insurance contracts, including health insurance, property and casualty insurance, auto insurance, and professional liability insurance.

Similarly, the FDIC may engage in what I term “regulation by deposit insurance” to address the consequences of its reliance on the Fed and OCC, in which the FDIC gives banks incentives to modify their behaviors through the imposition of dynamic and variable insurance pricing. The agency’s statute allows it to set banks’ insurance assessment rates under a “risk-based assessment system,” in which each bank is charged an amount based on “the probability that the [DIF] will incur a loss with respect to the institution” and “the likely amount of any such loss,” in addition to “the revenue needs of the [DIF].”^[1]Accordingly, the FDIC may increase assessment rates on banks that are more likely to fail, or to cause losses to the DIF if they do fail, than others, based on banks’ overall health or specific activities.

Regulation by deposit insurance gives the FDIC a practical and efficient mechanism for enacting its three principal functions without relying as much on other regulators. Rather than relying on the Fed and OCC to ensure that national and state-member banks comply with the FDIC’s regulations that allow the agency to better effectuate its insurance and receivership responsibilities, and rather than negotiate on prudential standards that apply industry-wide, the FDIC can incorporate these standards into its insurance assessment rates by providing discounts to banks that adhere to these standards or increasing assessments for banks that do not. Because insurance assessments are enforced by the FDIC, it need not rely on the other regulators to ensure compliance with its preferred regulatory standards.

There are also other benefits. The FDIC can calculate more accurate assessment rates that better align with the risks banks pose to the DIF. The point of a risk-based assessment system is to ensure that IDIs with less shareholder capital and riskier assets and activities pay higher assessment rates than their safer competitors, such that the former internalize the risks they pose to the DIF. Although the FDIC has enacted such a system, it has room for improvement, some options for which are discussed below.

Proposals for Regulation by Deposit Insurance

Using the FDIC’s authority to set assessment rates based on IDIs’ probabilities of failure and expected losses to the DIF, I propose three areas for which the FDIC should consider incorporating incentives into its risk-based assessment system.

First, the FDIC can encourage IDIs to meet minimum capitalization levels to lessen the likelihood of failure. Because banks with lower levels of shareholder capital are more likely to fail than those with higher levels, the banking agencies require banks to maintain capitalization levels above certain minimum thresholds.[2] Although there is likely no need for the FDIC to do so when the three agencies have imposed identical capital requirements, as is currently the case, the FDIC may increase (decrease) insurance assessment rates for banks below (above) the agency’s preferred minimums, regardless of what their primary regulator mandates.

Second, the agency may encourage IDIs to maintain long-term debt and holding company support to lessen the DIF’s losses when banks do fail. The goal of both options is to place losses in the first instance on banks’ investors – creditors and parent companies, respectively – instead of on depositors and the DIF. The FDIC could, for example, offer assessment discounts to banks that obtain eligible debt in sufficient volume or increase assessments on banks that do not. Similarly, the agency could decrease assessment rates for IDIs owned by holding companies that have entered into secured support agreements with the FDIC, which allow the agency to recoup losses from those holding companies in case of their bankruptcy.

Finally, the FDIC may encourage banks’ compliance with regulations that help the agency perform its insurance and receivership functions. The FDIC has enacted two such regulations: One requires large banks to create resolution plans that advise the FDIC on how to place the institutions through receivership should they fail, and the other ensures all IDIs have appropriate procedures to accurately report customers’ assets to the FDIC when insurance payouts are required. Yet, as described above, the FDIC relies on the OCC and Fed to enforce these rules. Instead, the FDIC increases assessments on banks that do not comply with these rules on the grounds that they improve the efficiency of the DIF’s functioning.

Conclusion

Although the FDIC is one of three banking regulators, its authority over the deposit insurance system allows it to function as a truly independent agency. My article explains how the FDIC can reassert itself, rather than rely on the other regulators as conflicted agents.

ENDNOTES

[1] 12 U.S.C. § 1817.

[2] See, e.g., 12 C.F.R. § 3.10.

This post comes to us from Professor Todd Phillips at Georgia State University. It is based on his new paper, “Regulation by Deposit Insurance,” available here.