The FDIC's Gift to Banks

The Federal Deposit Insurance Corp. isn't the only beneficiary of a plan to refill its coffers. The proposal, which the banking regulator announced on Sept. 29, also offers an intriguing way for financial firms to boost their capital and raise their profits.

Under the proposal, banks would prepay three years' worth of insurance fees, or roughly $45 billion. The money will help the agency dodge a cash crunch as it deals with a record number of failing institutions. So far 50 banks have been taken over by the agency in the third quarter, vs. a year ago. If the plan goes through, the banks would pay the cash up front but take the hit to earnings over several years. Banks that don't have the means to pay could seek an exemption.

It's a bit of financial legerdemain. Under accounting rules, banks record prepayments as if they had used the cash to buy an asset—in this case, FDIC insurance. Different types of assets have different capital requirements depending on their risk. The FDIC argues these assets are backed by the government, and the banks shouldn't have to hold any capital against them. If they did have to come up with additional capital to cover these assets, banks might balk at paying their insurance ahead of schedule. "The FDIC's guaranteeing it, and the federal government is guaranteeing the FDIC," says John F. Bovenzi, until May the agency's chief operating officer and currently a partner at industry consultancy Oliver Wyman Financial Services. "It looks like a creative way to deal with a difficult situation."

Plumper Bank Cushions

Here's where it gets interesting for the banks. Deep within the proposal, the agency calls for similar treatment for other assets backed by the FDIC, for the sake of consistency. Those assets include the roughly $300 billion worth of special, FDIC-guaranteed bonds issued since the financial crisis kicked into high gear late last year. Right now the bonds are considered akin to high-quality debt, and the banks have to hold $1.6 million of capital for each $100 million of the bonds they own. The shift means banks would no longer have to set aside money to cover potential losses on FDIC-backed securities. The result: Some banks' cushion of capital would look plumper practically overnight.

A similar change could add to profits. The FDIC is also looking at putting banks' deposits at other insured institutions in the same risk-free category. That could prompt banks to move some of the $388 billion in reserves they now warehouse at the Federal Reserve into other FDIC-backed institutions. If they do, banks could earn a much higher rate on the money. The Fed pays a paltry 0.25%, compared with about double that for bank deposits. "Banks will have a big incentive to take funds from the Fed and lend them to each other," says a banking analyst at a major money manager. "I could see some very creative deposit pools forming."

Some banking experts question whether the FDIC's proposal would have unforeseen consequences, particularly if banks spread their deposits around dozens of institutions. If bank failures continue to mount, the agency might find it difficult to untangle all the interlocking deposits. Says Mark Gertler, an economics professor at New York University: "If they all started doing this, the FDIC might reconsider the rule."