Sic Semper Tyrannis

In response to the onset of the Great Depression in 1932/3, the Glass-Steagall Act was passed to reform finance and relieve the economy. It was passed in two parts. The second act, called the Banking Act (1933), had three major provisions:

1. Separating commercial banking from securities dealing
2. Creating Regulation Q, which limited the ability of banks to provide interest on demand deposits
3. Creating the FDIC, the Federal Deposit Insurance Corporation

Of these provisions, only the last remains. I argue here that it shouldn't, and in fact, leaving it in place while repealing the other provisions of Glass-Steagall 2 is dangerous.

Follow up:

The FDIC provides insurance for "conventional" forms of bank deposits (checking accounts, savings accounts, and CDs), up to $100,000 per account. This was intended to restore confidence in the banking system during the Depression by protecting most of the deposited assets of regular folks.

But anything beyond the most superficial look at the system spurs the question of how FDIC could actually protect anything.

"ISSUES"

The FDIC holds reserves as a provision against potential losses of member banks. According to the FDIC's 2005 report, these reserves amounted to about $34 billion in that year, for just the bank insurance fund (the main fund). Yet, only $2.4 billion of this is in cash and equivalents -- the rest is in the form of US Treasury Securities! In other words, most of the "money" in the FDIC's reserves doesn't actually exist!

The distinction is significant. Based on the larger, US Treasuries-including number, the FDIC claims the insurance fund ratio is about 1.25% (it's "goal", conveniently enough), for about $2.7 trillion of insured deposits. But excluding the useless Treasury Securities and counting only cash, the insurance fund ratio is more like .08%. That is, for every $100 deposited under FDIC, only about eight cents are backed by reserves.

So we have here yet another shameful instance of US bond-based accounting shenanigans that totally undermine the solvency of a government financial service. How could the general public and various auditors miss this? How could such a thing even theoretically be useful?

In fact, a parallel institution, the Federal Savings and Loan Insurance Corporation (FSLIC), immediately went bankrupt when challenged by the S&L crisis in the early 90s. It was not-so-elegantly shut down and merged with FDIC. I suspect the FDIC would simply repeat this performance when faced with a banking industry meltdown at least on the scale of the S&L crisis (that is, $150 billion+ of losses... in 1990 dollars).

There is a special irony to this situation. The first half of the Glass-Steagall Act (1932), provided for the following:

1. Allowing US Treasury Securities to be used as financial collateral.
2. Relaxed the discount window collateral requirements.
3. Allowed the Fed to lend out the government's gold.

The first of these provisions engendered the use of US Treasury Securities as fully-fledged "money", which they are really not. A liquid financial market was resultingly created for them. This is bad enough when engaged in privately, as a substitute for real "investment". But the practice was eventually adopted by the government itself; hence an FDIC which holds most of it's assets in US Treasury Securities -- obligations from the government to itself. If a private entity listed such "assets" on it's balance sheet, it would be guilty of fraud under the very same laws the government itself ignores.

There seems to be other hanky-panky at play: the FDIC claims over 94% of it's member banks are "well-capitalized", which means they have at least 10% backing of deposits. But according to the Fed there are only about $40 billion (or less) of reserves on deposit in the banking system; if indeed the FDIC is correct in that the nominal value of deposits is $2.7 trillion, then all banks are sharing only about 1.5% of cash backing all of their insurable deposits. How this could even remotely lead to 94% of banks having at least 10% capitalization is beyond me. Something stinks to high heaven here.

IMPACT AND REMEDY

So it is clear that FDIC is just an elaborate illusion. No harm done then, right? Not much is spent on it, and it can't really do anything.

Not quite, I think. First of all, the FDIC has "monopolized" the market for banking insolvency insurance, while not actually legitimately providing the service. So essentially, there is no deposit insurance -- at least for solvency; theft and fraud are privately insured with sufficient adequacy!

The ultimate effect of this head-fake is that no one really looks at, or cares about, banking solvency. That's "the government's problem." Suddenly it becomes clear why woeful undercapitalization is endemic in the banking system. This is an ironic outcome to legislation passed to remedy banking failures, and it essentially makes the general public the unwitting least-cost bearer of risk for everything the banking industry does.

I therefore propose the abolishment of the FDIC. This would have two key effects:

1. Private, legimate deposit insurance for bank insolvency would be created, much as has been done currently for theft and fraud. People's deposits would actually be protected, because no private insurance company can get away with chiefly "investing" in IOUs to itself.
2. More importantly, a market would be created for bank solvency information. Suddenly it would matter how well a bank was capitalized; how high its cash reserves are. This would have to be measured in a real, meaningful way, as insurance companies have an interest in not going broke themselves. Deposit fees would be lower for insured banks which are better capitalized. One would likely even be able to look at "solvency ratings" produced for banks by insurance companies, akin to the credit ratings of today. Imagine the combined effect these things would have on where people put their money.

This could all be achieved by repealing the rest of the Banking Act of 1933 -- and not passing a single new law.

For good measure, of course, all of Glass-Steagall should be repealed. Monetizing US Treasury Securities has turned out to be a phenomenally bad idea, as has allowing the government to "lend" out it's gold reserves.

Fat chance, of course.