Peter Atwater Suggests Eliminating FDIC as Part of Banking Reform

Peter Atwater, one of the individuals responsible for building JP Morgan's securitization business during the late 1980s and early 1990s believes that doing away with the FDIC will help promote bank stability and soundness in the future. It's one of five recommendations he gives as part of banking reform. In an article posted on Yahoo Business entitled Five Suggestions for Banking Reform, he writes:

"Second, and at the risk of being bold, I believe the time has come to eliminate FDIC insurance. When the FDIC was created in the 1930s, it was intended to be a temporary solution. Today, it puts the US taxpayer on the hook for more than $7 trillion in bank liabilities. But as a consequence, depositor due diligence is non-existent. And putting Wall Street aside, this crisis has shown, even with specific oversight, hundreds of now-failed banks took excessive risk in their traditional banking businesses and their insured depositors neither cared nor were adversely impacted. Their risk was borne by the government, while they earned returns far in excess of comparable US Treasuries. If we're truly going to eliminate "moral hazard"/"too big to fail" we must eliminate deposit insurance in the process."

It's an interesting and bold idea, but one that ignores the reality of how FDIC insurance works and how it can be made better. First, banks fund and pay for FDIC insurance. The taxpayer does not. Yes, the fund is ultimately backed by the US Treasury but it has as of yet had to pay anything to depositors, even in the most recent financial crisis. Instead, the FDIC placed an extra levy on the banks to help recapitalize the fund. That seems entirely appropriate.

Second, without FDIC insurance, bank runs would become much more common and debilitating. Any news of a bank problem would be met with a rush of depositors trying to get their money out. A bank could collapse based solely on rumor. The orderly unwinding of a financial institution would be impossible.

Third, doing away with FDIC insurance assumes that consumers have access to the proper information to make decisions about bank viability, security, safety, and soundness. It is unclear if that information exists or that consumers would be able to process it. For example, even though Indymac was widely expected to fail for several weeks, a significant percentage of the deposit base had money there in excess of FDIC insurance levels. What is more likely to happen, is that after a few banks go under and consumers lose money, they'll begin to pull money out of the banking system and stuffing it under their mattress. That removes money from the banking system that can be used for other productive purposes.

A far more effective remedy would be to increase the percent that banks have to pay into the fund based on their leverage and risk ratios as well as their projected losses. Banks go through cycles of boom and bust and smoothing that cycle for consumers is the best way to help consumers, not removing any kind of bank responsbility for keeping their depositors whole. As we've seen, banks are incapable of self-regulating and could care less about losing investor, depositor, and government money.

The article also is sanguine about the Volcker rule, which recommends re-siloing banks based on whether they use consumer deposits or not.

"First, as much as I admire Mr. Volcker and the noble intentions of the "Volcker Rule," I'm afraid that attempting to re-silo the financial services industry is akin to trying to unscramble an egg. In fact, with all due respect to the myriad of regulators currently in place, I think our existing silo'ed regulation contributed mightily to our crisis."

In a sense, the end of Glass-Steagall and the repeal of the FDIC would remove two big pillars of bank regulation put in place after the Great Depression. I find it ironic that the banking system was relatively stable from the late 1930s through 2007. Is it coincidence that the banking system crashed so shortly after Glass-Steagall was repealed? What would happen if Great Depression remedies were further removed and FDIC insurance abolished?

Those that fail to learn from history are doomed to repeat it. What we need now are clear remedies to a broken banking system, not a return to a past that we know doesn't work.