Repealing brokered deposit law would be a costly mistake

Those of us who went through the savings and loan crisis and the rash of bank failures in the 1980s remember the devastating effect brokered deposits had in causing and driving up the cost of those collapses.

Despite the urging of the Federal Deposit Insurance Corp.’s then-Chairman Bill Isaac, Congress only addressed the issue after the fact, restricting brokered deposits through a new section of the Federal Deposit Insurance Act.

Since then, the FDIC has repeatedly studied brokered deposits, concluding that it is, in fact, correlated with a higher rate of bank failures as well as an increased cost of resolutions. That’s why it is disheartening to see the bank trade associations and even the FDIC now considering a repeal of that restriction in the FDI Act — the only law dealing directly with brokered deposits. Legislation was recently introduced in Congress to implement such a repeal.

While there have been significant changes in how banks gather deposits, the basic problems caused by brokered deposits remain. In 2011, Congress mandated that the FDIC published an extensive study on the issue, finding that as “brokered deposit levels increase, the probability that a bank will fail also increases.” Furthermore, the study also found that banks with higher levels of brokered deposits were also more costly the Deposit Insurance Fund in the event of failure.

In another FDIC study of the 2008 financial crisis, the agency again found a high correlation between brokered deposits and costly bank failures in the last recession, resulting in additional premiums that surviving banks paid to the DIF.

The FDIC’s analysis of bank failures during that period found that 47 failed banks relied heavily on brokered deposits, which represented 13% of the total assets of all failed institutions but 38% of DIF losses. As a result, the agency recommended at the time that Congress “not amend or repeal” the brokered deposit statute.

Yet now the FDIC and bank trade associations are apparently promoting a repeal with little explanation as to why these previous FDIC findings are no longer valid. Their argument seems to be that the regulation is too complicated and that changes in technology have made such regulation obsolete.

However, issues of complexity and technological change can be addressed by reworking the existing regulation. In its 2011 study, the FDIC concluded “the statute is sufficiently flexible to allow the FDIC to treat deposits, including new forms of brokered deposits, appropriately.”

In fact, the FDIC has already put forth major changes in a proposal on brokered deposits which is pending following a public comment period.

Most bankers agree that changes are needed. The regulation should be more clear, and the process for obtaining rulings less cumbersome. Some types of deposits that have been treated as brokered should not be. And there may be some deposits that are currently not treated as brokered which should be.

Even though the proposed rule provides new exemptions that in some cases look overly broad given the history and purpose of the brokered deposit statute, it doesn’t seem enough for some industry advocates who want to completely eliminate the law.

Proponents of the repeal say that it should be replaced with a law that gives regulators authority to limit the asset growth of banks that are less than well capitalized. This is misdirection.

First, bank regulators have long had the implicit authority to limit asset growth at troubled institutions, and have done so on individual cases. This has not solved the issue of the correlation between brokered deposits and bank failures.

Second, while brokered deposits certainly have fueled unsafe asset growth in many cases, there are other issues in using these deposits beyond asset growth. For example, noncore brokered deposits can run on, causing a liquidity problem if a bank is seen as troubled or can no longer afford to pay above-market rates on such deposits.

Third, an asset growth limitation does not affect a key problem with brokered deposits: It can impose additional costs in failed-bank resolutions. Indeed, the language in the proposal creating a new asset growth authority is itself complex and will lead to a very complex regulation that the industry may not like.

Finally, when banks purchase other banks, whether failed or not, the purchase price is noticeably lower since noncore deposits are of little or no value to the purchasing bank. This reduces the value of the selling bank and increases the FDIC’s losses when the bank fails.

The banking industry should work through the regulatory process that the FDIC has already started with its proposal. It should not advocate repeal of a law enacted to address a terrible problem in the industry, especially when there is historical proof of serious problems with brokered deposits that still exist.

If the current statute is repealed, the industry will eventually see the day when problems with brokered deposits reappear, resulting in higher insurance premiums and, as history has shown, the imposition of a more onerous and costly regulatory regime.