At a formal meeting on Thursday, April 11, the Federal Deposit Insurance Corporation (FDIC) announced the end of an interesting and important experiment. The FDIC announced that it would reimburse to banks $5.7 billion in prepaid premiums. The amount is what remains of premiums that the FDIC required banks to pay in advance to meet the unusual cash needs faced by the FDIC during the recent financial crisis.

When the crisis began, the FDIC’s Deposit Insurance Fund (DIF) held over $50 billion in funds. By the end of 2009, the FDIC estimated the DIF to have a value of negative $20.9 billion. The major part of that negative number was not experienced losses but rather the FDIC’s estimate of losses that it would experience from the foreseeable future failure of banks, which its accounting rules required it to recognize immediately in valuing its books. That is to say that the FDIC at that time had not run out of actual cash on hand and in fact throughout the recession never came close to running out of cash to meet its operating needs.

Nevertheless, those estimates were enough to make any manager worried. And with the purpose of the FDIC being to reassure depositors that their bank deposits were safe (at least up to $250,000 per account), it was considered wise for FDIC to meet its future funding needs well in advance.

What to do? All of FDIC funding since its inception has been paid for by insurance premiums assessed the banking industry. Recognizing that emergency conditions could arise, the law allowed FDIC to ask the Treasury for a loan. FDIC leadership was reluctant to do that, perhaps most significantly for the message that might send to the market place, the deposit insurer needing to go hat in hand to the U.S. Treasury for help.

Instead, FDIC leadership tried a novel idea. Their assumptions were that the losses on the fund were the proverbial bulge going through the snake, that over time—and not over a long period of time—continued insurance premiums paid by banks would cover all of the FDIC’s needs. But “eventually” does not meet immediate cash needs. To meet immediate concerns FDIC leadership announced in 2009 the plan to have banks pay 13 quarters of premiums in advance. That transferred to the FDIC $45.7 billion in funds at the end of 2009. From then on and throughout the recession, the FDIC had adequate resources at hand to honor all of its obligations as it continued to resolve failed banks. In fact, the $5.7 billion announced last week are the excess funds from those prepaid premiums that the FDIC, as it turned out, did not need. Hard to blame the FDIC for being a bit conservative in its loss expectations.

That is to say that, rather than going to the Treasury, the FDIC went to the industry for its financial backstop. Since the purpose of the FDIC is to support depositor confidence in banks, and since banks have always paid all of FDIC’s costs, this may be seen as all very appropriate.

The question is, is it legal? And if legal, is there any legal limits to how much premiums in advance the FDIC could demand from the industry? Is 13 quarters the maximum? Why not 14, 15, or 30? What tests may apply? Paying for future years assumes that the bank will be around in those future years, and it requires estimates as to how large those banks might be (since premiums are related to bank size). There were many other operational issues that the FDIC had to work with, with little statutory guidance.

Or is all of this an exemplary exercise of regulator and industry working together to defuse a crisis and maintain financial confidence. Hopefully these questions are academic, as we all wish that the FDIC does not find itself in such a bind again. The Dodd-Frank Act, in fact, has raised the minimum ratio of funds against insured deposits that the DIF is required to have on hand, from 1.15% pre-crisis, to 1.35%.

Those percentages may appear to some as small, but they seem to have allowed the FDIC, with emergency bank support, to have weathered a very serious and real stress test. Estimates are that the DIF will hold in excess of $90 billion when it is fully capitalized under the new DFA ratio. It already holds $33 billion today (even after the planned reimbursement). Experience tells us that having large amounts of money sitting around in Washington apparently idle can be seen by Congress as a honey pot to fund unrelated spending (history has witnessed many proposals in Congress to use FDIC funds in the past for housing and other unrelated purposes). And in any event, those are funds pulled out of service to the economy. Knowing that the industry can be called upon through advance payment of premiums may avoid having to put more honey into those pots. But does the law allow it? And if so, under what conditions? Or is it best to leave this all alone to allow careful and reasonable solutions to be found in the actual event, as we witnessed with the FDIC in 2009?

Here is the link to the FDIC’s staff memo made public last week discussing the condition of the DIF and the completion of the advanced premium program.

Here is a link to an American Bankers Association comment on the FDIC report.

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