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The financial reform bill's hidden blunder

Wednesday, June 30, 2010; A16

IN MANY RESPECTS, the financial regulation bill approved by a House-Senate conference committee lives up to its "reform" billing. But one little-noticed provision represents a step in the wrong direction. We refer to the permanent increase in the size of bank accounts eligible for federal deposit insurance from $100,000 to $250,000 -- retroactive to Jan. 1, 2008. It's a bailout for a relative handful of well-off customers that may also increase risks in the U.S. banking system.

Deposit insurance, funded by a fee on banks and administered by the Federal Deposit Insurance Corp., sets up a firebreak against bank panics and provides for orderly resolution of failed banks. Under current law, bank accounts are insured up to $100,000 each. A family of four, if it divides its funds among children, retirement and business accounts, can be protected for up to $1.2 million, according to Robert Pozen, senior lecturer at Harvard Business School. But, to stem the financial crisis of 2008, Congress upped the level to $250,000 per account -- but only temporarily, through 2013. As a result, 98.4 percent of all bank accounts are federally insured.

However, about 10,500 depositors of IndyMac and five other banks that failed shortly before the new ceiling went into effect felt aggrieved. Seems they had more than $100,000 on deposit and, even though the FDIC paid them 50 cents on the dollar above that amount, they wanted every penny -- and let Congress hear about it. Hence the provision making the $250,000 ceiling retroactive, at a cost to the FDIC of between $180 million and $200 million. Some depositors said they were misinformed about deposit insurance by IndyMac branch managers. But these are people who already had $100,000 in the bank -- not exactly the most pathetic victims of the crash. The deposit insurance rules are easily available online; it's not too much to expect anyone capable of saving up $100,000 to read them.

Indeed, the main problem with raising the limits and making them permanent is that it relieves some of the largest and most capable bank customers, many of them not individuals but companies and nonprofit groups, of the responsibility to check out the institutions to which they entrust their nest eggs. In the absence of this small but significant incentive for market participants to police bank balance sheets, the entire job will fall on the overworked FDIC. At the margin, this encourages weak banks to offer high interest rates on large deposits -- which they will then use to leverage risky investments. And when they fail, the FDIC will be on the hook, for more than would otherwise have been the case.

No doubt community banks appreciate the provision, to help them compete with the too-big-to-fail boys. But all-but-unlimited deposit insurance aids smaller banks only in the most shortsighted sense of extending imprudent government backing to them, too. Federal deposit insurance was one of the great New Deal reforms. Like all government guarantees, it must be carefully calibrated so as not to enable unduly the very risky behavior against whose consequences it protects. This provision does not pass that test.

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