How the FDIC Failed WaMu and IndyMac

Business by on September 28, 2008 at 10:23 pm

In a 10 day span, $16.7 Billion was withdrawn in deposits from Washington Mutual (5% of $307 Billion in assets). In 11 days, depositors withdrew $1.3B of IndyMac’s $18.9B in deposits (~7%). Both bank runs were stimulated by (correct) concerns about the financial conditions of the banks. Both banks were FDIC insured.

FDIC Purpose

In my limited understanding of the FDIC, it fulfills two main purposes:

  1. Provides federal insurance for depositors with less than $100K in any single account at any FDIC-insured institution.
  2. Prevent bank failure. There are essentially two components of its efforts to prevent failure:
    1. Require adequate reserves: All FDIC insured institutions are required to maintain certain levels of capital reserves. If an institution falls below certain thresholds, the FDIC can change management or take over the bank entirely.
    2. Prevent bank runs: The federal insurance and reserve requirements provide depositors with comfort knowing that they cannot lose their money. This comfort should prevent rumors from becoming reality and depositors from simultaneously making withdrawals.

How the FDIC Failed

With both failures, the FDIC served one of its two purposes - it ensured that depositors didn’t lose money. However, it failed to prevent the bank runs that actually triggered the failures.

So, why the failure? I’ve got three theories:

  • The effort required to move money between institutions is trivial. The FDIC was created in 1933. Most consumers today can move money between banks with less than five minutes of effort.
  • Consumers don’t understand the FDIC. Bank failure means you lose your money. To the mattresses!
  • Consumers don’t trust the government. They simply don’t believe that their money is protected.

I’d love to see polling data on this, but I’d be willing to bet that the second reason is the likely answer. A common notion that I see/hear popping up is that some believe that Fed has 99 years to repay their insurance. Here is FDIC’s take on that myth:

Misconception Number 3: If a bank fails, the FDIC could take up to 99 years to pay depositors for their insured accounts.

This is a completely false notion that many bank customers have told us they heard from someone attempting to sell them another kind of financial product.

The truth is that federal law requires the FDIC to pay the insured deposits “as soon as possible” after an insured bank fails. Historically, the FDIC pays insured deposits within a few days after a bank closes, usually the next business day. In most cases, the FDIC will provide each depositor with a new account at another insured bank. Or, if arrangements cannot be made with another institution, the FDIC will issue a check to each depositor.

I can understand liquidity concerns, but I’d hope that most of us can survive a day or two of illiquidity. In fact, WaMu debit cards continued to work as normal the day after the failure.

I thrilled that the government retained Suze Orman on Sep 22 to launch an ad campaign informing the public. They need to think bigger with more advertising. I’d love to see the candidates incorporate some of this messaging into their ubiquitous advertising.

However, technology is beginning to antiquate some of the FDIC legislation. Bank runs are far easier to trigger now than they were during the S&L crisis and certainly back in 1933. Some of this legislation needs to be rethought to provide mechanisms to account for the sheer speed with which a run can occur. And the FDIC limit set in 1980 needs to be raised.

Then again, I may be the last person with my money still in a bank…

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