How to give the FDIC some clout

(breakingviews.com) -- The Federal Deposit Insurance Corporation needs to add prevention to its stock of cures.

Its bank deposit insurance fund is running low, so it has asked its charges to prepay three years of premiums. Yet 90% of banks paid no assessments from 1996 to 2006 when their profits were healthy. Such pro-cyclical policies punished the prudent and rewarded risky lenders.

The laws governing the fund require the FDIC to keep its kitty at no less than 1.15% of insured deposits, which it does by assessing banks based on their deposits and their regulators' rating of riskiness. When the fund hits 1.35% of deposits, highly-rated institutions receive a 50% refund on their assessments. When the fund hits 1.5%, the refund is 100%.

There are two big problems with this. First, these thresholds are too low to keep the insurance fund topped up over the banking cycle. The fund's average size was around 1.3% of deposits in the decade preceding the recent crisis.

Even allowing for recent rule changes that would boost that a bit, this magnitude of buffer has proved woefully insufficient -- hence FDIC's need to pass the hat round now.

Second, regulators have been too easy when grading the riskiness of banks. IndyMac is a standout example. The Californian mortgage lender's failure will cost FDIC an estimated $9 billion. Yet IndyMac paid no deposit insurance premiums for nearly its entire decade or so of independent existence because it was rated a safe institution by its primary regulators, most recently the Office of Thrift Supervision.

Both problems can be addressed. Lawmakers could force institutions to pay levies into the FDIC fund continuously, over-stuffing it during the good times in preparation for the bad. Such a structure would also slow somewhat the growth of risky institutions, because they have to pay more than safer ones. And financial firms that fail would at least pre-fund more of the cost of the cleanup.

And regulators could grade institutions more critically to ensure risk-based levies like the FDIC assessment work as expected. It's also possible the biggest "too big to fail" institutions should pay extra because of the huge burden on FDIC's fund if one of them falls on hard times.

True, FDIC's fund is now so depleted that it will take years before it hits the current ceiling again. But fixing a problem is best done before it happens again. It's time lawmakers made the FDIC fund countercyclical.