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Systemic Risk and Deposit Insurance Premiums

In the wake of the financial crisis, many economists are trying to come up with creative new ways to deal with systemic risk: the risk of a "wholesale bank failure" and failure of the financial system in general. I just finished reading Judge Posner's recent book, A Failure of Capitalism.
In the wake of the financial crisis, many economists are trying to come up with creative new ways to deal with systemic risk: the risk of a "wholesale bank failure" and failure of the financial system in general. I just finished reading Judge Posner's recent book, A Failure of Capitalism. In it, Judge Posner makes a convincing case that individual bankers can (and did) make rational decisions that, at least in the aggregate, greatly increase systemic risk. I don't wish to go into the details of that analysis here; I just want to assume its truth.

When rational actors make decisions that create negative externalities, it often falls upon the government to adjust the incentives to account for those outside costs. In banking, for instance, Citigroup might make certain decisions that increase its risk of bankruptcy to 1%. For a smaller bank, that risk would only be negligibly important: the bank could fail and go into receivership. But for Citigroup, of course, such a failure would have broader effects: it would not be able to keep the (many) promises of payment it regularly makes to other banks (cascades); it would create a "fire sale" situation wherein bank assets would have to be sold by the FDIC at a sharp discount; and confidence in the economy overall would sharply decline. A systemic risk regulator would intervene to prevent a Citigroup (or one of its similarly-sized cohorts) from taking these individually rational (but systemically risky) actions. Even Tyler Cowen suggests that we might need such a regulator, and it probably needs to be the Federal Reserve. I respectfully disagree.

I think the best way to regulate systemic risk is to use the insurance premiums charged to banks by the FDIC's Deposit Insurance Fund (DIF). In very simple terms, the FDIC charges banks an insurance premium that is used to cover depositor losses when banks fail. Under the current system, under 12 U.S.C. 1817, the FDIC charges a "risk-based" premium that is supposed to be based on: (1) the probability that the DIF will incur a loss for that institution (i.e., that the institution will fail); (2) the likely size of any such loss; and (3) the revenue needs of the Fund. Trouble is, the premium is only based on the individual size of each bank's risk to the Fund. Therefore, when calculating Citigroup's premium, the FDIC does not include any of the "contagion" effects noted above. The FDIC isn't actually charging for the real "likely size of any loss" that the bank will suffer from a big, interconnected bank's failure.

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I've seen a few different studies outlining how we could actually set the premiums to account for the systemic effects of a bank failure. I'm not going to venture into that. My only point is this: properly scaled, deposit insurance premiums that include systemic risk would obviate the need for any "systemic risk regulator." If banks that create systemic risk faced increased premiums of any significant size, one would expect them to adjust their behavior to reduce the risk. In fact, the best approach might to charge punitively high premiums. One could anticipate that these punitive premiums could quash the moral hazard created by government bailouts; banks would know that they would pay a high price for setting themselves up to be "too big to fail." Best of all, even if a bank was so brazen as to generate systemic risk in the face of high premiums, the money collected from the bank's premiums would be enough to clean up the (system-wide) mess resulting the bank's failure.

Of course, to accurately assess the premiums and let the market work its magic, the FDIC would need access to an enormous amount of information at banks. Not a problem! The FDIC has the right to examine any FDIC-insured institution if the FDIC's board of directors finds the examination is necessary "for insurance purposes." 12 U.S.C. 1820(b)(3). That would simplify the issue of setting up an entirely new systemic risk regulator with the authority to examine the books of market participants.