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America’s Lessons in Killing off Toxic Banks

A couple of years ago, I spent some time brainstorming with officials from America’s mighty Federal Deposit Insurance Corporation. It felt rather like meeting doctors from ER, or an emergency medical ward. For FDIC officials have handled so many sick American banks in recent years, they have developed a slick drill: if a bank is deemed bust, FDIC “shock troops” will arrive, typically on Friday night, seize control, reassure staff and depositors – before either closing the banks or selling it on.

Performing this operation demands tricks of the trade; FDIC officials have learnt from bitter experience that electricity bills need to be prepaid to avoid panic if the lights go off. But the drill is usually slick enough to avoid alarm. So much so, in fact, that many people do not even know that 445 ailing banks have been closed in America since 2008 (or an average of two a week). And while many are tiddlers, the deceased banks include big(ish) groups such as Washington Mutual.


There is an important lesson for Europe here. Two weeks ago, eurozone leaders announced plans to create a banking union, in their latest effort to quell panic. The news duly sparked a brief market rally, amid hopes that European politicians are finally trying to grasp their banking nettle.

Last week, however, I met European financial officials in Dublin, and was clear that many elements of this “union” remain uncertain; it is unknown, for example, whether a union will “just” involve joint bank recapitalisation, or include joint deposit insurance and supervision too. So, as European regulators and policy makers thrash out their ideas about how to rebuild confidence, they might do well to take a look at how “union” has worked in America, and how this has helped quell the 2008 US banking shock.

Part of this story revolves around the so-called Troubled Asset Relief Program (Tarp) that the US government implemented in 2008; this provided badly needed recapitalisation and transparency for the banks. However, the other, less-discussed element is the FDIC, and the Friday night “death drill”. For this has also stabilized the system, and as such offers lessons for eurozone politicians and regulators.

One is that it pays to have a predictable and consistent routine for spotting and killing troubled banks. More specifically, the FDIC system works well because there are clear rules of the game (most notably, that when the FDIC judges a bank insolvent, it can seize its operations, wipe out shareholders, then sell or liquidate it.) This does not always prevent controversy; in 2008, for example, there was a row about how the FDIC handled WaMu’s bonds. But the FDIC has the benefit of having existed for eight decades, and so has a well-worn, credible routine.

Second, a regulator needs to have a powerful “brand” in the eyes of the public – in the sense of embodying simple, easy-to-understand principles. Consumers in America do not usually know the details of how the FDIC operates; but they know that accounts with the FDIC stamp are guaranteed against losses, up to $250,000. The message is crystal clear, and thus readily understood. This is crucial for quelling panic and contagion. Witness the contrast with the money market fund sector, whose status is more ambiguous.

Third, the FDIC benefits by having federal, not regional, status. This ensures that the supervisors who take the decision to kill a troubled bank are not from the same, local community, and so cannot be co-opted or influenced. It also means that the FDIC draws its funding from a wide base (in this case the financial industry). That puts it on a stronger financial footing, which is important, given that it has cost the FDIC about $88billion to protect depositors since 2008, as those 445 banks have died – and the agency expects to spend $12billion more in the next four years.

Fourth, the FDIC’s experience shows that regulation need not be a zero-sum game; on the contrary, the agency has a long history of collaborating with other regulators in America to supervise banks. Banks sometimes complain this creates unnecessary, wasteful duplication; it also occasionally causes issues to fall between the cracks. But mostly, it is beneficial, since collaboration creates checks and balances.

Now it will not be easy to transplant all these lessons to Europe. The FDIC, after all, has mostly “only” dealt with domestic banks, not cross-border banking behemoths, and the legal code in Europe is radically different. Most crucially, Germans politicians appear unconvinced that a mutual insurance scheme is a good idea at all.

However, leaving aside these legal and political niceties, the most important lesson is that having a simple message and purpose is crucial for building trust. The FDIC “works” because it does what it says: kills ailing banks, while protecting depositors. If the eurozone could build similar clarity, with whatever regulatory structure it chooses, it might start building a better financial world. Or, put another way, if the eurozone could kill 450-odd Spanish, Greek or French banks without a consumer or market panic, the euro might have a more viable future. Politicians take note.

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