What Works About the FDIC?

Ezra Klein says we need financial regulations that work even under the worst of political leaders:

In particular, the Federal Deposit Insurance Corporation will still work. Those are the folks we created in the aftermath of the Great Depression to insure your bank deposits. And what’s interesting about their structure is that they are totally automatic and universal: It doesn’t matter if President Palin’s nominee to head the Federal Reserve thinks the banks are in tip-top shape and markets are proving themselves to be straight magic. The FDIC still insures your deposit. And that’s why we no longer have consumers bank runs in this country. It’s why nobody lined up outside Citibank even when it seemed like they might collapse.

You can’t fully protect against the problem of bad regulators. But if you’re seriously trying to fix the financial system, your proposals have to assume bad or complicit regulators. That, after all, is what you see in a massive bubble, and what we saw in the run-up to the recent crisis. If Alan Greenspan or Ben Bernanke had thought we were going down the tubes, they could’ve stopped it. But they didn’t think that. They thought all was well. So the question is how you create a system that pushes against bubble mentalities. And the answer we came up with during the Great Depression is you don’t give regulators that much discretion.

I think it’s important to be clear as to what about the FDIC works, since the FDIC does a number of things. One, it raises funds from the banks it insures. Two, it bails out the people to whom a failed bank owes money (i.e., depositors). Three, it’s supposed to engage in prudential regulation to prevent the banks it insures from getting into trouble.

When you talk about regulator error or regulatory capture for the people who are supposed to be watching “shadow” banks, I think we’re primarily talking about failing on plank three—letting institutions lever up during the boom and go broke during the bust. And it’s not really clear to me that the FDIC does incredibly well on this score. When economic problems arise we have a bunch of bank failures. What the FDIC is good at is that it has a resolution mechanism that’s well-understood by the relevant people, that works smoothly, that’s politically legitimate, etc. This all points to the need for the government to have a workable “resolution authority” for these large, diversified financial institutions. Some people think the Dodd draft has that, others aren’t so sure. But either way, this is a somewhat different issue from the question of whether or not the prudential regulation stuff relies too much on discretion.