When Banks are 'Too Big to Fail', Deposit Insurance Fund Doesn't Measure up

FDIC officials will huddle Tuesday to discuss how to replenish its depleted deposit insurance fund. On the surface, the issue appears fairly straightforward -- does the fund have enough money and, if not, what's the best way to top it off?

Of course, it's nowhere near that simple (surprise!). The first, and most obvious, reason is politics.

As pundits have pointed out, the FDIC has several options for refilling the deposit insurance fund. These include borrowing money from the Treasury Department, getting a loan from banks and imposing a special assessment on lenders. It also could take bolder steps. For instance, the government could condition its loan guarantees on banks getting the proceeds as uninsured deposits and then backing them with equity. That would force banks to share more of the costs if they failed, rather than heaping most of the risk on taxpayers.

The battle lines over these approaches are being drawn. Given the searing public anger at the banking industry, the FDIC will be leery of tapping its line of credit at Treasury. And banks, most of which are losing money, understandably oppose an assessment that could hurt their earnings. Financial companies, too, will weigh the political overtones of lending money back to the government while many individuals and businesses are struggling to get a loan.

With an eye on next year's mid-term elections, lawmakers will do the usual calculus as they balance rank-and-file interests against special interests. Yesterday, for example, we saw House Financial Services Committee Barney Frank, D., Mass., shooting down the idea of imposing an assessment on banks. Regulators will hedge their own bets, while stumping for their institutional interests.

Also complicating the question of how to shore up the FDIC's deposit fund is that the answer relates to another thorny, and larger, issue on everyone's mind these days: what do do about financial companies that are "too big to fail." The real danger to the deposit fund isn't that a string of smaller banks go bust; it's that a single money center bank fails (Citigroup comes to mind).

Sure, as Chris Whalen pointed out yesterday, the FDIC can turn to the government or the banking sector in order to refill its coffers. But at a cost. The FDIC, for example, has said its last special assessment would reduce pre-tax income at profitable banks for 2009 by 5.1 percent; unprofitable banks would see their pre-tax loss rise by an average of 2 percent. More broadly, having to fund the losses of a huge bank would affect profitability for the entire industry, which in turn would ripple into the lending environment.

The growth of these mega-banks is a direct consequence of the growing concentration of assets in a handful of companies. If the latest financial crisis and the Savings & Loan debacle in the 1980s have made anything clear, it's that the U.S. deposit insurance system was not designed for such large companies controlling such a large share of available financial assets. The fund, which grew out of the Great Depression, was set up in the 1930s as protection against certain kinds of risk.

Those risks have changed and grown. Regulation hasn't kept up. The proposals likely to be under consideration next week for patching up the deposit fund don't tackle this deeper structural problem.