Language in the so-called CRomnibus spending bill being debated in the Senate would undo a prohibition on FDIC-insured banks trading certain kinds of complex financial instruments. The provision may be dangerous, but not for many of the reasons that were being thrown around by lawmakers last week.
The Dodd-Frank Act, which reined in various dubious Wall Street practices in 2010, forced banks to “push out” most swaps and derivatives trading activity to affiliates that are capitalized separately from the bank.
Allowing them back in may or may not be a good idea, but it does not mean that when banks lose money on swaps and derivatives trades, the Federal Deposit Insurance Corporation will have to make them whole. It also doesn’t suggest that, when a bank fails, the taxpayers have to bail out depositors.
However, people who spent any time listening to House Minority Leader Nancy Pelosi (D-CA) rail against the massive spending bill Thursday might have come away thinking exactly that.
With the provision in the CRomnibus allowing banks to make derivatives trades, Pelosi said, “[W]e say to Wall Street, ‘You can engage in risky activity with your derivatives, and the FDIC will insure your action.’ That's just plain wrong.” She added, “With this bill now we are saying the exposure, the recourse is with the U.S. taxpayer. Just plain wrong.”
Well, it is wrong, but probably not in the way Leader Pelosi meant.
First of all, despite the fact that it is a federal agency, the money the FDIC holds in the Deposit Insurance Fund, and uses to reimburse depositors in failed banks, doesn’t come from taxpayers. It comes from the banks themselves.
The FDIC is, at heart, an insurance company. It charges banks premiums for their insurance coverage. Those premiums are used to capitalize the DIF. Furthermore, when funds in the DIF run low, the FDIC is empowered to increase premiums to recapitalize it.
Asking banks to be nothing but giant mattresses under which people can stash their money.
To be sure, FDIC insurance comes with “the full faith and credit” of the U.S. government, and the agency has the authority to borrow from the U.S. Treasury if necessary, but even in the worst years of bank failures that followed the financial crisis, it never had to do so.
Second, there is no sense in which the FDIC is on the hook to make banks whole if a swaps deal or derivatives trade goes bad. The FDIC insures deposits – hence the name – not the bank itself. If a bank burns down, the FDIC won’t pay to rebuild it. But if management didn’t have adequate fire insurance and the bank can’t reopen, it will pay out money from the insurance fund to cover the losses of insured depositors.
Pelosi last week argued that the provision tacked on to the spending bill “allows big banks to gamble with money insured by the FDIC.”
Here’s the thing: Big banks (and small ones) gamble with FDIC-insured money every day. It’s called lending. One can object to the kinds of risks banks take, but attacking them for taking any risks at all is tantamount to asking them to be nothing but giant mattresses under which people can stash their money.
What Pelosi did was conflate a single bad swaps deal with a catastrophic, systemic banking crisis in which the government (most likely the Treasury Department and the Federal Reserve, not the FDIC) steps in to bail out failing banks in order to forestall the collapse of the financial system.
If that sounds familiar, that’s because it’s exactly what we lived through in 2008, and it was nightmarish. But drawing a straight line between allowing insured banks to trade swaps and derivatives and financial Armageddon isn’t really fair.
There is a legitimate public policy concern about allowing huge financial institutions to trade on the perception of an implicit government guarantee.
For one, the Dodd-Frank Act specifically bars the federal government from spending taxpayer dollars to bail out a failed bank. While many doubt that the prohibition would be honored in the face of a systemic crisis, it remains on the books.
There’s no question that there are other legitimate concerns about the provision tacked on to the spending bill. On the process side, it was passed with no debate or discussion. On the policy side, there are strong arguments that such a prohibition might be a good idea – a case Sen. Elizabeth Warren has made forcefully on the floor of the Senate, where debate over the spending bill raged over the weekend.
Warren spoke out strongly against the bill as well, ahead of the House vote Thursday night. “This Congress can’t be here to say ‘What can we do to improve the profitability of a half-dozen large institutions and shove all the risk off to the American people again.’ This Congress has to stand for a little more safety and security in our financial system.”
Warren isn’t wrong about the fact that the provision would mainly benefit a handful of big banks, or that it’s largely about profitability. Swaps and derivatives contracts sold by insured banks carry a price premium because of the perception that the bank has government backing. And there’s a legitimate public policy concern about allowing huge financial institutions to, in effect, trade on the perception of an implicit government guarantee.
However, it is far from clear that allowing banks to engage in those trades would create massive systemic risk. In theory, at least, this could be reduced to a matter of regulatory oversight. Banks could be allowed access to the market under strict supervision and reporting requirements.
Others would argue that banks, already highly regulated in advance of the financial crisis, managed to find ways to take excessive risk anyway, and wound up on the verge of collapse.
Lawmakers are right to argue that the provision was inserted into the spending bill without adequate debate. But the subject of the debate needs to remain on the real problem swaps and derivatives trades might make for banks, not imaginary ones.
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