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In tough times, troubled companies use desperate measures to survive. Historically, though, when banks make such moves, taxpayers are left holding the bill.

That's the motivation behind an FDIC decision that took effect at the beginning of the year. Even though the new FDIC rules will potentially reduce the amount of interest that savers earn on their bank deposits, they'll also take away the ability of dying banks to make reckless offers at the public's expense.

Avoiding the death throes
Historically, banks that were threatened by a lack of capital have had plenty of incentive to do whatever it took to attract deposits. Offering high-rate CDs and other accounts encourages customers to open or add to their accounts, thereby potentially giving the bank an extra chance at survival.

Conversely, there was no incentive for banks not to take extraordinary measures. If a bank failed to survive, neither depositors nor the bank itself suffered as a result of offering high deposit rates. As long as customers stayed under the FDIC insurance limit, they got repaid in full. And once a bank failed, the higher rates simply drained more capital from the bank, making it more costly for the FDIC to reimburse bank customers for lost deposits.

The FDIC rule goes a long way toward preventing the damage a bank can do in its death throes. It imposes a limit on the amount of interest a bank can pay if it doesn't qualify as well-capitalized. Such a bank can't pay more than 0.75 percentage points above prevailing national rates.

Pros and cons
Critics of the proposal suggest that the move pushes the banking system one step closer to nationalization, as government regulators take the place of market forces. But there's no doubt that the industry benefits hugely from the perception of safety that FDIC insurance confers upon bank deposits, since it dispels fears of bank runs that are among the most lasting impressions from the Great Depression.

Moreover, at current rates, the 0.75-percentage-point limitation actually gives banks a lot of leeway. Consider, for instance, the recent rates on one-year CDs:


Rate on 1-Year CD

Nationwide Financial Services (NYSE: NFS  ) Bank


Discover Financial Services (NYSE: DFS  ) Bank


ING (NYSE: ING  ) Direct


MetLife (NYSE: MET  ) Bank


AIG (NYSE: AIG  ) Bank


American Express (NYSE: AXP  ) Bank


Source: Bankrate. As of Jan. 14.

According to Bankrate, the average rate on one-year CDs is 1.57%, which would give banks the latitude to pay as much as 2.32% on such CDs without running afoul of the FDIC rules. And although longer-term CDs pay somewhat higher rates -- the average five-year rate is currently 2.91% -- 0.75 percentage points is a huge spread over those prevailing averages.

A limited sample
In addition, the FDIC itself admits that the rules won't apply to very many banks. When the rule was first announced, fewer than 250 banks -- less than 3% of the number of banks across the nation -- fell under the "less than well capitalized" standard. Banks like Wells Fargo (NYSE: WFC  ) took substantial steps to improve their capital ratios throughout 2009. While the problem isn't gone, banks now appear to be in much better shape than they were at the heart of the crisis.

Unfortunately, the same can't be said for the FDIC, which clearly needs to take steps to shore up its own financial health. With 140 banks failing in 2009, the FDIC is already making efforts to raise revenue, including a proposal to base banks' deposit premiums on their relative risk, and front-loading premium payments for the next several years into a single lump-sum payment.

The mortgage crisis threatened the fabric of our entire financial system. Although many of the immediate concerns from late 2008 have been addressed, deposit insurance remains one of the lynchpins of the banking system. Without it, we could easily return to the bank runs and widespread panic of the 1930s. With the FDIC in critical condition, any steps that foster competition and prevent troubled banks from taking advantage of the deposit insurance system are long overdue.

If you're worried about the markets, you're not alone. Todd Wenning explains why now's the time to get defensive.

Fool contributor Dan Caplinger thinks FDIC insurance is the financial equivalent of mini pretzels -- he just can't get enough of either one. He doesn't own shares of the stocks mentioned in this article. American Express and Discover Financial Services are Motley Fool Inside Value picks. The Fool's disclosure policy is still waiting for its bailout application to be approved.

Read/Post Comments (3) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 15, 2010, at 7:23 PM, Gorm wrote:

    While I endorse the actions of the FDIC, increasingly the FDIC, because of limited resources and number of failures, is "caving in" to demands of bidding acquirers and pretty much letting them have their way with depositors.

    Have experienced acquirers dump interest rates on CDs to as low as .05% and .70% for CDs with terms of 1-5 years.

    In some cases acquirers are slow to notify depositors of changes, offer no viable options to continue a deposit, and put the costs of slow payouts on the backs of depositors.

    The FDIC is tolerating mistreatment of acquired depositors it doesn't tolerate on new depositors to a healthy bank.

    Call it leverage or opportunity, but some banks are taking the FDIC and consumers for a ride!!

  • Report this Comment On January 15, 2010, at 9:14 PM, xetn wrote:

    The smart move that is long overdue is to end the Fed and FDIC which create the moral hazard that encourages bankers to engage in high risk transactions that lead to bank bailouts or takeovers.

    Elimination of these two entities would put the risk of real failure through bankruptcy squarely where it belongs. It would also take the taxpayer out of the process.

  • Report this Comment On January 18, 2010, at 4:17 PM, pedorrero wrote:

    Just another example of "rearranging the deck chairs on the Titanic." Fractional reserve banking is, by some points of view (none of them in banking or government!) by definition dishonest. At heart, it claims that people can deposit their money, and the bank can loan out many times the total amount of deposits as loans, and still be able to pay back a depositor on demand. Works well most times, fails when there's a "run." Take away the gold and silver and even most of the paper money for all that, and you have a multiply dishonest system. It's all really just a confidence game, and a sorry sight when it finally dies.

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