Wall Street isn't the only place that misunderstands incentives...

Amidst the flood of bailout programs, the FDIC's program to expand insurance to unsecured bank debt has received relatively little attention. The FDIC program - the Temporary Liquidity Guarantee Program (TLG)- essentially extends FDIC's Deposit Insurance Program to banks' bonds. Without this insurance, banks could experience "bank runs" caused by bondholders' unwillingness to refinance bonds as they come due. Of the virtues one would want in a government intervention, this program has many. It is highly effective in its objective, it keeps government separated from management decisions, and it minimizes cost to taxpayers. However, the FDIC plan is rife with moral hazard issues that could be minimized using existing FDIC mechanisms.

This program turns FDIC into an AIG-like bond insurer: participating banks pay an insurance premium to have their debt insured against losses. AIG insured $500B in bonds, and required several hundred billion dollars of capital injection. The FDIC plan insures over $1.4 trillion in debt, with no initial capital other than fees collected through the program. These fees are based solely on the how long the debt will be guaranteed for, at a maximum of 1% of insured capital. This implies less than 1% of losses. Losses in excess of that would be funded by special assessments on existing banks (although backed by the full faith and credit of the government).

This mechanism, while eliminating direct costs to taxpayers, is one of two moral hazard problems in the TLG. The first is the special assessment: a responsible bank would now be on the hook for the mistakes of the less prudent banks. If a bank has to pay for the downside of bad loans whether they make them or not, shouldn't they make bad loans so they can at least participate in the upside? Massive TLG assessments on prudent banks incentivize banks to take risky bets so that they can participate in both the upside and downside of bad loans - just the opposite of the behavior the FDIC would like.

Second, the FDIC - for reasons unknown - decided to charge rates on newly secured deposits independent of the riskiness of banks. The normal insurance progam charges different fees based on capital levels and oversight. Banks that take on additional risks to deposits again gain upside without having to pay for it under the current pricing. Instead, fees should increase when banks increase risk, aligning incentives to make good loan decisions.

The FDIC should scale the fees charged by this program using the existing risk-based deposit system, and Congress should alleviate the moral hazard of the TLG by capitalizing the insurance fund directly instead of charging conservative banks for the poor lending of their competitors. While Congress is considering this issue, they can fix the same flat-rate distortion that exists in other government schemes, such as the Pension Benefit Guaranty Corporation.