FDIC, Fed Funds & Leen’s Lodge
August 6, 2011
David R. Kotok
What is the difference between -13 and +7? The answer is 20. Twenty is the market-based pricing of the cost of the FDIC asset-based fee assessment. For the first time, we were able to see its impact. It is important to understand this calculation in order to fully appreciate what is happening in the financial markets.
The Bank of New York has imposed a fee of 13 basis points (13/100ths of 1%) on large deposits. With this policy, the Bank of New York is essentially stating if you put your money in our bank, we will charge you an interest rate for the privilege of depositing with us. At the same time, the Federal Funds Rate, which is applied in the exchange of overnight reserves between and among banks, traded at +7 basis points. It is here we find the spread of 20 basis points.
Why would the Bank of New York impose such a cost on depositors? Simply put, it was losing money. How was it losing money? It has to pay an asset-based fee to the Federal Deposit Insurance Corporation, and the excess reserves on deposit at the Federal Reserve are counted as assets in the computation of the fee.
Dear reader, as this gets a little complicated, I am going to simplify as much as possible. Therefore, I am going to make some minor technical errors about the composition of the items in order to get to the calculation.
The Federal Reserve pays a bank 25 basis points as an interest rate on its overnight deposit of excess reserves. If you are an American bank, you have to subtract your asset-based FDIC fee from the 25 basis points in order to determine your net result. The asset-based fee varies based on a formula and is dependent on the composition of your assets, liabilities, and other factors that would require a technical discussion of the computation of fees beyond this commentary. The point is this: the Bank of New York concluded it had to charge its depositors. The underlying message in this policy is to tell depositors to withdraw their money and go to another bank.
Think about what it means for a large bank of great stature to tell its significant institutional depositors to take their money elsewhere. The Bank of New York could only do this if it were losing money on those deposits, which means the net of the FDIC fee at the margin and the cost of reserves, which is the Federal Funds Rate, or the proceeds if you sell excess reserves, was such that the Bank of New York had to establish a negative interest rate, or a fee on deposits.
The implication of a 20-basis-point calculation using a market-based price is that it is the first time we are able to see the negative impact of the FDIC fee assessment. We wrote about it in the past, and we called it “the wedge.” We talked about it at Leen’s Lodge with several colleagues, many of them skilled in monetary dynamics, a number of them involved in institutions; and all of them agreed: there is some cost attached to this “wedge.” In addition, the market-based pricing due to the Bank of New York revelation enables us to establish an estimate of cost. From that, we can infer what the cost might be for other large depository institutional-servicing organizations.
Now, dear readers, recall the estimates of the value of the $600 billion dollar QE2, which was announced a year ago. Various estimates priced the benefit in interest-rate equivalents of 2, 2 ½, or 3 basis points per $100 billion dollars. The value of QE2 in terms of reduced interest rates was somewhere between 12 and 18 basis points. We now see the Bank of New York in a market-based transaction relative to the Fed Funds Rate, saying the cost of the FDIC assessment is 20 basis points.
Take 20 basis points, subtract the midpoint of the estimate of QE2, at 15 basis points, and you have a net imposition on the banking system by the FDIC assessment of an amount that fully unwinds the entire stimulative effect of QE2, plus removes from the market part of the stimulative effect of QE1.
If you want to understand why the stock market reacted so harshly to this news, examine the conclusion. QE2 has been fully neutralized by the FDIC. Furthermore, the FDIC “wedge” is extracting part of QE1. Let us take this to the next step. What can the Federal Reserve do in order to counter the negative impact of the FDIC fee assessment? It can do nothing. That would be a form of driving deposits from American banks to the US subsidiaries of foreign banks. This is significant because the US subsidiary of a foreign bank does not pay the FDIC assessment, but it does have the privilege of selling excess reserves to the Federal Reserve; and so therefore, it receives the benefit of the Fed stimulus.
The Federal Reserve could alter its program. It could raise the interest rate it pays on excess reserves. It could neutralize the FDIC fee. It could alter the composition and lengthen out the term of excess reserves. There are many things the Federal Reserve could do.
What can the FDIC do? First, it could recalculate the fee assessment and exclude excess reserves as an asset. It essentially could conclude that excess reserves have a long-term role in which they will be very minor in a normalized economy, and that they are very large only because of this unusual and special Federal Reserve policy. Secondly, the FDIC could admit its error in judgment. They have imposed a fee, even though they were warned about it by some serious researchers. They ignored them, the Federal Reserve leadership ignored them, too, and now we are seeing the consequences. The consequences are severe in the capital markets and in the economic outlook, and they should step up and change the rule. Therefore, excess reserves should be excluded from the computation of the assessment. The mix can then be altered, and the subsidy from the Federal Reserve will go to American banks, not foreign banks. Furthermore, those banks will now have a level playing field and be able to redeploy capital in some more positive form.
Let us suppose that the FDIC were to change the form of the fee assessment tomorrow and announce that henceforth excess reserves do not count as an asset in the computation of the FDIC fee. If the FDIC were to take that action at once, markets would begin to normalize and realign within days. It would be a fee change in the pricing at the short end of the yield curve, and the stock markets, capital markets, and the world would like the result.
It is now time for the FDIC to admit it made a mistake. It is time for the Federal Reserve to say to the FDIC, we think you made a mistake; you interfered with Fed policy, and it can be corrected immediately with a rule change.
We do not know if we are right, but we think we are. We do not know if the fee change will have the desired effects, but we suspect it might. More importantly, the Federal Reserve and the FDIC should debate this issue with transparency. They should examine it with clarity and seek opinions besides our own. They should analyze whether the Bank of New York action is telling them something about market-based pricing of their policy. They should disclose the results so there can be discussion about them among those professionals who have the skills to understand and analyze these transactions.
This is one of our major conclusions from our dialogue at Leen’s Lodge. We bounced this off professionals – economists, monetary activists, and other who have great skills in monetary economics and policy. We do not all agree on the numbers. We do not all agree that 20 basis points is the cost. One thing is clear: we do all agree that there is a “wedge” created by the FDIC assessment, and that it is doing a disservice to the United States, to the implementation of policy, and is making the Federal Reserve’s role more difficult.
Leen’s Lodge is a terrific place for discussion. Only in an environment under the Chatham House Rule can such conversations take place. Only in a relaxed environment can they be fully explored. It has been a privilege and a pleasure to be able to participate in this activity. The next step is in the hands of the Federal Deposit Insurance Corporation.
This commentary was written before the S&P rating cut was announced. We will have more to say on that in a future discussion.
David R. Kotok, Chairman and Chief Investment Officer
Category: Think Tank
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