Some Thoughts on Reforming the FDIC

Greg Baer is the President and Chief Executive Officer at the Bank Policy Institute, a nonpartisan public policy, research and advocacy group that represents universal banks, regional banks and the major foreign banks doing business in the United States. 

The FDIC has been criticized over the past year for the behavior of its employees,^[1] its Chairman,^[2] and its culture more broadly.^[3] Those are important concerns, but they obscure another chronic and now quite pressing matter: the agency’s performance of its mission. Since the 2008 financial crisis, the FDIC has taken on new responsibilities while continuing to execute its traditional functions. And 16 years in, the agency clearly appears to be failing on multiple fronts. A fundamental rethinking of its mission is overdue. New leadership at the agency and the next Congress should consider broad FDIC reform.

Inventory

The FDIC is an agency with multiple different functions: it serves as

1. An insurance company that collects premiums and pays out claims;

2. A bankruptcy court that resolves failed banks;

3. An investment bank that, incidental to its bankruptcy court role, in many cases must sell the assets and liabilities of failed or failing banks;

4. An examiner of thousands of banks, albeit only one of the 10 largest U.S. banks, and two of the largest 25;

5. A regulator, not only for the community banks that it examines but, because banking agency rules are generally uniform by law or practice, also for the largest U.S. banks – think Volcker Rule, Basel capital and liquidity requirements;

6. Given the Dodd-Frank Act requirements for the largest banks to maintain a “living will,” a co-writer, along with the Federal Reserve, of secret liquidity regulations for the largest U.S. banks; and

7. An arbiter for M&A transactions, not just for the banks it examines and banks seeking to merge with uninsured institutions but increasingly, at least according to its own (debatable) reading of the law, banks wishing to buy assets from an uninsured institution in a transaction that would not be considered a “merger” under the laws of any state.

Performance

So, how is the FDIC performing its functions, and how could it improve?

The Core Functions

The FDIC appears to collect premiums and pay out deposit insurance claims efficiently. This is its core function and expertise. Similarly, the FDIC has demonstrated expertise in resolving small banks, where the bank or its assets are generally sold to a single bidder. In nearly all cases, the depositors and other creditors of the bank are protected in a relatively simple proceeding orchestrated by the FDIC, using powers conferred on it by the Federal Deposit Insurance Act.

The examination function of all the federal banking agencies appears to have reached a crisis point, with a focus on the immaterial and counterproductive mandates.^[4] The FDIC’s own report assessing its supervision of Signature Bank paints a picture of major staffing issues, management lapses, slow communications and poor work quality. That said, there is no reason to believe that the FDIC is performing any better or worse than the other agencies, and any reform in this area would need to be deep and broad-based, not FDIC-specific.

Matter Requiring Immediate Attention

The FDIC does not appear effective at resolving large banks. By all accounts, its resolution of Silicon Valley Bank was disastrous. Most objectively, we know that the cost was initially estimated at $15.8 billion, then $16.3 billion, then $20.4 billion, then back to $19.2 billion. There has been little explanation of why. Approximately $2.5 billion of that cost was attributed to a decision to fund the resolution with a loan from the Federal Reserve at an interest rate that included a 100-basis-point penalty, and a decision not to pay off that loan for several months even once the FDIC was able to do so.^[5]

The FDIC also selected complex structures for at least $33 billion of real estate asset pools that were apparently inconsistent with the FDIC’s mandate to resolve failed banks in cost-efficient ways. By structuring some of these asset pools as joint ventures in which the FDIC would retain majority equity stakes and insisting on onerous financing, approvals and consent terms, the FDIC limited demand for these assets and thus inherently depressed their sale price.^[6]

As FDIC Vice Chair Travis Hill has said, “the FDIC has an obligation to minimize losses when resolving failed banks, and it is hard to argue we did that here.”^[7]

Anecdotally, it is clear that these substantive problems are downstream of the most significant failing, the actual operation of its investment banking function.^[8] People who dealt with the FDIC over that first resolution weekend describe a scene of disorganization and confusion. The details have never emerged because the FDIC enforces non-disclosure agreements that prohibit prospective bidders from criticizing the process. The FDIC itself has never provided a full explanation of the events; multiple FOIA requests related to the resolution either remain unanswered or have produced limited information; and the FDIC’s Inspector General has not yet issued a report.

Stepping back, it may not be reasonable to expect the FDIC to operate as an efficient investment bank. During the thrift crisis and the days of the Resolution Trust Corporation, when it was resolving over 740 failed banks and thrifts, the FDIC employed a large number of people with expertise in asset sales and the like. Fortunately, the days of mass failed institution resolution are over, but the experts who handled it are long gone from the FDIC. There is thus a strong case for outsourcing this function to a private-sector firm with the expertise and staffing to handle it. Much like an existing and successful FDIC program to line up potential new CEOs for banks put in receivership, a pre-approved list of investment banks could be established to market failing banks and improve resolution outcomes, consistent with a clear mandate from the FDIC.

Matter Requiring Attention

In the medium term, the legal parameters for FDIC action should be rethought, either as an administrative matter by the FDIC or a legislative matter by Congress. Current law requires the FDIC to resolve every failed bank in the way that results in the least cost to the DIF. This wise and seemingly simple mandate has been clouded over time. Those who seek to bid on failed banks and failed bank assets have little transparency into the FDIC’s approach to this test. As a result, bidders remain unnecessarily in the dark when composing bids to submit to the FDIC, often on very tight timeframes in an already uncertain environment. There is no policy benefit to such opacity. 

Changes to the approach might improve the chance of pursuing the best measure of resolving a failed bank and potentially dramatically reduce the long-term cost of resolutions.

Eliminating Distractions

Over the past decade, the FDIC has been granted or assumed for itself significant new duties that merit revisiting.

Liquidity Regulation

The FDIC’s least known power has been its use of resolution plan approval power to impose a secret liquidity regime for large banks; that regime – not the liquidity coverage ratio or net stable funding ratio – has been the binding constraint in some cases. Even if this is a proper role for the FDIC, there appears to be little case for the regulatory requirements it imposes being secret. Separately, the FDIC has created another major role for itself by requiring bank-level resolution plans for all banks with assets of $50 billion or more. While there is no express authority for these bank-level plans, the FDIC asserts broad discretion to demand extensive information, require “capabilities testing” on demand, and bring enforcement actions under this framework, even for banks for which the FDIC is not the primary federal regulator.

Merger Review

Meanwhile, the FDIC’s existing merger review process is plagued by ever-increasing timing delays that are unpredictable and often extensive, routinely diverging—often significantly—from the FDIC’s purported timeline of 60 days from receipt of a substantially complete application.^[9] The FDIC appears to be imposing non-public requirements and engaging in regulation through merger approval. There are of course real costs associated with the “regulatory purgatory” that applicants frequently face, with the “uncertainty [that] looms over M&A approvals [resulting in] customers, shareholders and employees of the target bank [being] left on the hook indefinitely to see share prices drop and employees depart.”^[10] The FDIC’s recently finalized Statement of Policy on Bank Merger Transactions does nothing to resolve this problem and instead introduces novel requirements that purport to extend the FDIC’s jurisdiction beyond the scope of the Bank Merger Act.

Most recently, the FDIC has decided to issue a prescriptive corporate governance proposal that represents a sharp departure from existing policies and practices of the other federal banking agencies, state law and widely accepted corporate governance principles. The proposal includes a mandate of stakeholder capitalism — that the board of an FDIC-supervised bank must take into account the interests of the public and the FDIC (regulators) on par with the interests of the institution and its shareholders. Of course, the FDIC would determine whether a bank was serving all those stakeholders (including itself) in an acceptable manner.

The FDIC’s new initiatives are not only of highly debatable legality and policy merit — they also (perhaps not coincidentally) represent the FDIC operating far outside the realm of its expertise. Perhaps not surprisingly, it also is doing so often through vague and opaque processes, where its work cannot be judged.

Rulewriter

The FDIC’s expanded rulewriting authority appears over-broad and counterproductive. Someone once observed that if the nation’s insurance companies set highway speed limits, then we would all be driving 15 MPH. Thus, the FDIC has historically, institutionally been opposed to banks taking on risk, most notably in capital markets. That opposition includes being the only agency to see value in the leverage ratio, which ignores risks and disfavors the holding of low-risk securities that is a necessary component of a capital markets business. It was granted joint authority to write regulations under the Volcker Rule, even though it had no institutional experience in securities trading, leading to enormous uncertainty, until the flawed approach was substantially revised.

The FDIC is one of the agencies that represent the United States at the Basel Committee on Banking Supervision, even though the focus of those rules is on internationally active banks that the FDIC does not examine. According to recent reports, the FDIC will only examine one U.S. bank subject to the Basel rule in the United States. Given the demands on the agency and its mandate, perhaps a reconsideration of its role here is warranted. On the other hand, the FDIC rightly participates in the International Association of Deposit Insurers, which is the global standard-setter for deposit insurance systems and the principal forum where deposit insurers from around the world meet to share knowledge and expertise.

Legal Structure

Since enactment of the Dodd-Frank Act, the FDIC has had an odd structure where the majority party is represented by the Chairman, the Comptroller of the Currency (ex officio) and the CFPB Director (ex officio); the minority party holds the Vice Chair position and the one undesignated spot. The presence of the CFPB Director is odd. This statement is in no way a denigration of the role of CFPB Director; it is an important one. But this role requires no special expertise to set deposit insurance premiums, administer a bankruptcy, or examine a community bank for safety and soundness violations.

Another larger question looms about the FDIC, which is its funding. While the taxpayer is the ultimate guarantor of deposit insurance, the fact is that the FDIC’s losses are paid by banks, either immediately through a special assessment (as happened in 2009 and 2023) or over time through general assessments.^[11] This situation creates a form of moral hazard: the FDIC is free to resolve banks however it sees fit, knowing that it will never have to answer to taxpayers or their elected representatives in Congress. Banks, which actually bear all the risk, have no ability to challenge its actions (or even complain about them, pursuant to NDAs).

This situation seems to argue further for outsourcing the FDIC’s investment banking function. It also makes the case for clear rules for how the FDIC administers its responsibilities and greater transparency in its operations, lest politically attractive yet higher-cost options be chosen.

Conclusion

In short, the next FDIC Chair and the next Congress have a lot of work to do to restore the reputation of the FDIC. Of course, part of that is installing new leadership and changing its culture. But a lot of it also is making sure the FDIC has a sensible mandate, a rational set of incentives, and the skills it takes to do its job.

[1] Joon H. Kim, et al., “Report for the Special Review Committee of the Board of Directors of the Federal Deposit Insurance Corporation,” Cleary Gottlieb Steen & Hamilton LLP, April 2024, and Rebecca Ballhaus, “Strip Clubs, Lewd Photos and a Boozy Hotel: The Toxic Atmosphere at Bank Regulator FDIC,” Wall Street Journal, Nov. 13, 2024

[2] Rebecca Ballhaus, “FDIC Chair, Known for Temper, Ignored Bad Behavior in Workplace,” Wall Street Journal, Nov. 16, 2024

[3] Jennifer L. Fain, Inspector General, Top Management and Performance Challenges Facing the Federal Deposit Insurance Corporation, Federal Deposit Insurance Corporation Office of Inspector General, February 2024

[4] Greg Baer, “The Bank Examination Problem, and How to Fix It,” Bank Policy Institute, July 17, 2024; Raj Date, “Banks Aren't Over-Regulated, They Are Over-Supervised,” Open Banker, Sept. 10, 2024; “Culture & Conduct Risk in the Banking Sector: Why it matters and what the industry is doing to address it,” Starling Trust Sciences, LLC, June 2024; and Greg Baer, “US Banking Agencies Have an Operational Risk Problem,” International Banker, Aug. 29, 2024

[5] Jeff Huther, “The FDIC’s Unusual Loan from the Federal Reserve,” ABA Banking Journal, March 5, 2024

[6] Although the FDIC cited its statutory mandate with respect to affordable housing under the Federal Deposit Insurance Act as the reason for the joint venture structure, it did not explain why the complex structures it chose were revenue-maximizing, cost-efficient, or otherwise optimal.

[7] Remarks by Vice Chair Travis Hill at the American Enterprise Institute, “Reflections on Bank Regulatory and Resolution Issues”, July 24, 2024

[8] For details on the failings of the FDIC’s process with respect to both SVB and Signature Bank, see Greg Baer, Bank Policy Institute, Letter to the FDIC Office of Inspector General, July 10, 2024

[9] Applications Procedures Manual, FDIC 4-23

[10] Representative Barr, Bloomberg Gov’t, Transcript of House Fin. Servs. Comm.: Fin. Inst. Subcomm. Hearing on Merger Policies of the Federal Banking Agencies (May 1, 2024), at 10.

[11] The one exception was the thrift industry in the 1980s, where there was indeed a taxpayer bailout. But those were different times, and it reflected the extraordinary risk of a charter that concentrated risk among its holders.

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