In the land before time...

I posted economic commentary to my Facebook page. And last September I pointed out that WaMu was offering interest rates a full 130bps better than HSBC and 100bps better than ING Direct on their 12month CDs. Of course the reason for this was obvious then. WaMu knew their balance sheets were deep in the red and they need a fast injection of deposits to shore things up. Unfortunately for WaMu what ended up happening was a lot of their own customers simply transferred deposits out of their checking accounts and into high-yield CDs.

The moral hazzard here is that WaMu understood there was a very real risk of being arrested by the FDIC and that the FDIC had voluntarily honored the yields IndyMac was offering on their CDs (IndyMac was doling out high interest rates for the same reason). The thing is, no bank is going to make any money with those rates. The only reason a bank like WaMu would offer such rates given the circumstances would be to try to protect share and boldholders. But the protection is being financed by the implicit guarantee that the FDIC will insure customer CDs. Afterall, if WaMu is clearing struggling and on the brink of collapse, what customer is going to invest in their CDs unless they are confident the FDIC will insure the deposit?

So about that moral hazzard, seems the FDIC has taken notice and is beginning to act:

The Board of Directors of the Federal Deposit Insurance Corporation today proposed for comment a regulatory change in the way the FDIC administers its statutory restrictions on the deposit interest rates paid by banks that are less than Well Capitalized.

Prompt Corrective Action requires the FDIC to prevent banks that are less than Well Capitalized from soliciting deposits at interest rates that significantly exceed prevailing rates.

Continues:

Concerns about Moral Hazard. In the insurance context, the term "moral hazard" refers to the tendency of insured parties to take on more risk than they would if they had not been indemnified against losses. The argument is that deposit insurance reassures depositors that their money is safe and removes the incentive for depositors to critically evaluate the condition of their bank. With deposit insurance, unsound banks typically have little difficulty obtaining funds, and riskier banks can obtain funds at costs that are not commensurate with their levels of risk. Unless deposit insurance is properly priced to reflect risk, banks gain if they take on more risk because they need not pay creditors a fair risk–adjusted return. A truly risk–based assessment discourages such risky behavior. The moral hazard problem is particularly acute for insured depository institutions that are at or near insolvency but are allowed to operate freely because any losses are passed on to the insurer, whereas profits accrue to the owners. Thus problem institutions have an incentive to take excessive risks with insured deposits in the hope of returning to profitability.emphasis added