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Community Banks Cry Foul, but What's Fair?

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By Steven Pearlstein
Wednesday, May 13, 2009

We're hearing a lot these days from well-run regional and community banks that feel that they are being punished for the mistakes of the Citigroups and the Countrywides.

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As you might expect, these bankers find it galling that they've been lumped together in the public mind with bankers who made lousy loans, lost gobs of money and nearly brought down the global financial system. But what adds injury to insult is that these bankers are now being forced, in the middle of a recession, to pay dramatically higher premiums to replenish the government insurance fund that is used to insure bank deposits and rescue failing institutions.

The prudent bankers are right to be angry about having to pay for the recklessness of their competitors. What they conveniently overlook, however, is that their complaints are virtually identical to those being made by their credit card customers who have never missed a payment but are being hit with high interest rates because of the reckless borrowing of others.

After all, if it is unfair for prudent banks to be punished for the sins of reckless lenders, why is it any less unfair for prudent consumers to be punished for the sins of reckless borrowers?

We are now knee-deep in the metaphysics of risk pooling, which, as it turns out, is what both insurance and credit cards are all about.

It is the nature of insurance that those who don't get into traffic accidents or don't set their houses on fire will wind up subsidizing those who do. To minimize this cross-subsidy, which to many looks like unfairness, insurers go to elaborate lengths to calculate, in advance, the probability that any particular policyholder will make a claim, and then reflect that probability in the premium they charge. But while the insurer may be quite certain that there is a one-in-10 chance of a major claim, they don't know which one of the 10 it's going to be.

When a policyholder finally makes a claim, the one in 10 is identified and his premium invariably goes up, but in most cases, even that does not fully recover the cost of the claim. In the end, the cost is passed on to all the other policyholders.

Moreoever, if a crime wave suddenly results in a rash of car thefts or a hurricane blows through an entire community, premiums are likely to go up for everyone. Why? Because there is no other way for the insurance companies to replenish their reserves and survive. The same goes for recessions and bank deposit insurance.

In a similar fashion, credit card companies, using credit reports and other databases, have become extremely sophisticated in calculating the probability that any consumer will default on his payments -- and that probability determines how much credit is extended and at what rate. Once somebody misses a payment, he suddenly identifies himself as the bad risk. The card company raises his rate to reflect that reality and minimize the cross-subsidy from other cardholders.

Of course, if the economy falls into a recession and lots of people suddenly lose their jobs and their wealth, then it's like a hurricane -- the card companies have no choice but to raise rates for good risk as well as bad, or face the prospect of going out of business.

So is any of this fair? If by fairness you mean that people pay only for their own mistakes, or their own bad fortune, then clearly it is not. But if you think about it, that is the nature of any risk-pooling mechanism.

If it were possible to predict which drivers will get into accidents or which banks will fail, and adjust premiums accordingly, then there would be no unfairness, no cross-subsidy -- and no insurance companies. People could simply insure themselves. Alas, life is not so predictable.

That's why the bankers' complaints about higher FDIC premiums ring rather hollow. If they were so prudent and so prescient, they ought to have complained back when they saw their competitors making all those risky loans with insured deposits. Instead, the "prudent" banks were not only silent, but in many instances they joined with reckless colleagues in pushing for lower premiums and lighter regulation. They are now paying for that sin of omission.

By the same logic, consumers shouldn't be surprised that credit card companies are raising rates and lowering credit limits even for cardholders who haven't missed a payment. It may be reasonable for the Federal Reserve or Congress to bar banks and card companies from applying higher rates retroactively to past balances -- after all, a deal is a deal. But consumers should understand that bankers are not simply blowing smoke when they warn that limiting their ability to charge higher rates to riskier customers will result in lower credit limits and higher rates for everyone else. Given the credit card orgy of the past decade, that may be just what we need.

Steven Pearlstein will host a Web discussion today at 11 a.m. at washingtonpost.com. He can be reached at pearlsteins@washpost.com.


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