Surprise Move: The Fed Pulls Back on Deposit Insurance

Norbert Michel / January 08, 2015

Yesterday’s release of the minutes of the Federal Open Market Committee meeting in December revealed very little new information on the Fed’s overall monetary policy stance. The headline statement was that “the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.”

Translation: We’re not doing anything different for now.

But the report included both good and bad news regarding the Fed’s overall reach into financial markets. The bad news is that the Fed has extended its experimental Overnight Reverse Repurchase (ON RRP) facility for another year.

As pointed out previously, this program turns the Fed into a borrower of last resort as opposed to merely a lender of last resort. If the program is made permanent, money market firms will have a ready-made place to park their cash for a risk-free return.

In the event of market turmoil, money market funds would have absolutely no reason to buy, for example, the commercial paper of the non-financial firms (such as PepsiCo and Home Depot) they normally buy. One unintended consequence of the ON RRP, therefore, would be to divert funds away from non-financial firms.

The good news?

The Fed appears to have shelved an experiment called “segregated cash accounts,” another program that would have further entrenched the Fed’s role in financial markets. These accounts would have allowed the Fed to expand deposit insurance beyond the FDIC insured limit of $250,000.

Commercial banks’ customers with more than $250,000 in their bank account would have been able to deposit cash directly in a Federal Reserve district bank via a “segregated” account. If the commercial bank then failed, the money in the segregated account would have remained safe.

The Fed had been pushing both of these ideas as a necessary policy tool during these supposedly unusual times, but that defense is as feeble as the ideas are dangerous.

To begin with, federally insuring deposits may sound great to policymakers, but it introduces moral hazard into the banking system. The ability to attract deposits no longer reflects banks’ true risk exposure, which produces an incentive to take more risk.

Expanding federal insurance against financial loss is all but certain to make the financial system less stable, even if it’s done via the Federal Reserve.

In general, the problem is that these types of programs create more “safe” assets for large investors and put taxpayers on the hook for losses. The more of these kinds of investments the government creates—even if it does so via the Federal Reserve—the more it reduces investment in private markets and the more it distorts asset prices.

At the very least, these Fed programs will magnify any rush out of private capital markets during a crisis, at exactly the time the funds are most needed in private markets. Some policymakers want us to believe that extending these types of policies even further will prevent future crises, but historical evidence suggests otherwise.

To begin, investment banks were assured emergency access to Federal Reserve credit in 1991, almost two full decades prior to the crisis. Second, the pre-2008 trend was that the U.S. government was guaranteeing (and making) more loans—not fewer. There is also the Fed’s long history of direct lending to potentially insolvent firms.

The truth is that free enterprise tends to function nicely when individuals risk losing money in the hope of making a profit. The possibility of loss tempers their actions.

When the government takes loss out of the equation, it guarantees profits to a few on the backs of taxpayers. Nobody should be surprised that this process resulted in highly leveraged financial firms.

If Congress really wants to stabilize markets and protect taxpayers, it will minimize the Fed’s reach into markets. A great start would be as follows.

• End the Fed’s lender-of-last-resort function.
• End The Fed’s role as a financial regulator.
• Require the Fed to implement rules-based policy.
• Direct the Fed to wind down quantitative easing.
• Require the Fed to terminate its Overnight Reverse Repurchase (ON RRP) facility.

More broadly, Congress has to allow financial firms to assume the risk of their operations, as should be the case with any businesses in any sector of the economy. If expanding taxpayer protection to investors really did stabilize financial markets, we wouldn’t be having this debate right now.