Earlier this week, the FDIC reported on how the banking industry fared during the second quarter. Better, but still not so hot summarizes the conclusions. But, buried in the data are deposit-flow statistics that tell us something important: the FDIC’s new rule that bases deposit-insurance assessments on assets, not deposits, is having the perverse effect we feared when we read it. In sharp contrast to the rest of the industry, the nation’s biggest banks bulked up on insured deposits during the second quarter, shifting from funding sources without the FDIC seal of a safety net to those backed by the U.S. Government’s full-faith-and-credit guarantee. That’s ending moral hazard – not.
First, the facts. According to the FDIC, total deposits in the U.S. banking system increased by only 1.7 percent during the second quarter. But, the nineteen largest banks scarfed up $241.4 billion – a 12.6 percent increase – in domestic deposits with balances over $250,000. More than half of this came from large noninterest-bearing transaction accounts with unlimited deposit insurance coverage. Smaller banks scored only a 2.8 percent increase in deposits with an unlimited draw on the DIF. The data also show industry-wide declines in other funding sources, with the biggest drop (8.1 percent) in secured borrowings other than FHLB advances. The data do not break out the percentage drop here by bank size, but we believe the bulk of this reduction came from them, not smaller institutions that generally don’t have ready access to wholesale funding sources.
Now, why these data matter. The Dodd-Frank Act changes the way the FDIC charges deposit-insurance premiums. Doing the bidding of both the FDIC and community banks, the law changes the assessment base from domestic deposits to assets. Then, in its rule implementing the law, the FDIC came up with a system that tries to set these asset-based premium assessments on what it thinks leads to big-bank risk. The methodology underpinning the premiums is, at best, opaque, but we’ll concede that it captures some features of high-flying banks. What it doesn’t do, though, is reflect what should count in premium assessments: the risk not to the bank’s shareholders and creditors, but that to the DIF. That’s what premiums are supposed to pay for – deposit-insurance coverage (see the FDIA). Other risks are addressed in the not-insubstantial rulebooks directed their way.
How does the new system perversely create more risk to the DIF? The numbers above tell the tale. DIF premiums aren’t cheap and, in current interest-rate conditions – when funding costs vary by only a basis point or two – they are a deciding factor. In the days when banks paid two percent or more to attract checking accounts, ten or fifteen basis points (bps) weren’t vital market factors. But, when demand deposit accounts (DDAs) offer ten bps or so, the DIF premium doubles the cost of offering the product. Thus, when DIF premiums were based on products like DDAs, big banks with access to wholesale-funding markets used other funding sources – exempt from premiums along with FDIC coverage – to the greatest extent they could, paying the higher rates demanded by institutional investors in return for the slightly higher risk of uninsured funding.
Now, from an FDIC-premium perspective, the asset-based assessment system makes banks indifferent to their funding sources – DDAs backed by the DIF cost no more than overnight funding from a money-market fund even though the FDIC and, by inference, the taxpayer stand behind the DDA. With DIF premiums no longer a deciding factor, the nineteen biggest banks can and, as demonstrated by the data, now are bellying up to the FDIC. For the first time, big banks can offer institutional investors truly risk-free liabilities at no added cost to the biggest banks. Cool, especially in these parlous times.
Of course, the impact of this funding-market shift poses risks to the FDIC. In the second quarter, hundreds of billions ducked for cover behind the FDIC’s sticker. When the 3Q data are out, we expect they will show an even more dramatic tale, as billions will flee for safety in covered funding sources backed by the FDIC. In fact, some banks are so awash with these funds that even they don’t want them anymore. Thus, as we feared, the new risk-based premiums on large banks are risk-based in only one direction: to the FDIC