In the aftermath of the Great Depression a number of weaknesses of the banking system were highlighted. One of the major flaws of the banking system was its reliance on the deposit multiplier. The concept is that a bank lent many more times than the money it had as deposits. In a normal economic environment the probability of all the depositors withdrawing their amounts is very small.
However, in times of crises, people become skeptical of banks and prefer to hold cash. When all bank customers simultaneously want to withdraw their deposits, there is a run on the bank. The new legislation was mainly focused on the fact that banks were unable to provide any satisfactory insurance on deposits, making Bank runs frequent.
The Banking Act of 1933 established FDIC as a temporary government corporation, which had the authority over member banks and supervisory rights over non member banks. The initial insurance limit covered by FDIC was 2,500 USD which has grown to 250,000 USD after the passing of Dodd-Frank Wall Street Reform and Consumer Protection Act.
There have been many notable crises in the past decades which involved the FDIC. The first major crisis was faced during the late 1980s when almost 800 savings and loan associations failed. The result was the assimilation of a parallel institution of the FDIC called Federal Savings and Loan Insurance Corporation (FSLIC). The financer at the end was the common taxpayer. This particular debacle cost taxpayers an estimated $150 billion to resolve.
Present Financial Crisis
The recent financial crisis, which was the start of the current recession, also involved the FDIC. FDIC was involved partly because the crisis stemmed from the non performing loans of banks and shadow banks. Shadow banks were linked to FDIC via the main stream banks. The majority of the non performing loans were Mortgages and mortgage backed securities.
In order to allow banks to cleanup their portfolios, FDIC launched an initiative called LLP (Legacy Loans Program (PDF)) aimed at ridding the banks of toxic debt and replacing it with healthy regular debt. In mid-2009, up to 150 Banks had non performing loans above 5% of their holdings. This is treated as a leading indicator for the future need of a bail out or insolvency managed by FDIC.
Role of FDIC in the Banking System
Any account, checking accounts and savings account both if insured by the FDIC are back by the “full faith and credit” of the US government. All branches of a bank are considered part of the single bank and similarly any online bank which is an extension of a regular bank is considered part of the original bank.
To become members of FDIC, banks have to meet certain guidelines for their accounts and capital. It uses a classification based on the risk based capital ratio. A well capitalized bank with a capital ratio of 10% or higher is considered safe. An undercapitalized bank with a ratio below 8% is monitored by the FDIC and can have its management changed if the ratio falls below 6%.
Effectiveness of FDIC as a Regulator of the Banking Sector
The FDIC has a number of tools at its disposals to encourage compliance amongst banks. However, very often in times of crisis, the inadequacy of FDIC is revealed. Its role as a regulatory threat is very effective however its ability to manage a crisis such as a liquidation is often criticized. This is partly due to the fact that once a bank has defaulted, it is extremely difficult to payout all the creditors their due shares. The FDIC does liquidate holdings and presses the banks debtors to pay, however, the issue often ends in pro rata allocations of funds.
FDIC’s role in the recent crisis was also questionable due to its blatant bargaining with competing banks to take over the failing ones. The case of Guaranty Bank in Texas is one such case where the FDIC agreed to split the losses resulting from Toxic debt with BBVA Compass, a rival bank. It has come under heavy fire for allowing the heads of rival banks to profit disproportionately from the crisis.
Despite all of these shortcomings, the FDIC has managed to prevent any major break of a bank run as seen in the early 20th century. Apart from its dealings in times of crisis the FDIC remains a potent regulator in the US Banking industry.