By William Isaac, Published by

In recent days some observers have questioned whether the Federal Deposit Insurance Corporation has been responsible in reporting the condition of the deposit insurance fund. One pundit went so far as to assert that the FDIC “has a habit of denying reality.” Strong stuff!

The charge is bogus, as I will explain in a moment. But first I want to focus on a broader, related subject that has been bothering me for a long time – the seemingly irresistible urge of some people to make outlandish statements in times of trouble.

For example, last November, in the middle of a worldwide financial panic, an analyst for an investment banking firm asserted that the eight largest banks in the U.S. needed $1.2 trillion of additional capital. Reporters asked what I thought. The assertion was so off the wall that I was almost at an uncharacteristic loss for words. All I could muster was, “Why not $2 trillion or $3 trillion . . . where do people get their numbers!?”

In 1991, at the crest of the great banking and S&L crisis of the 1980s and early 1990s, a headline in the Washington Post screamed that the FDIC fund was insolvent by $100 billion. The story relied on a study by a consultant and a professor, titled “Banking on the Brink: The Troubled Future of American Finance.”

Acting FDIC Chairman Skip Hove and Federal Reserve Governor John LaWare held a joint news conference to rebut the study. After the news conference one of the study’s authors issued a statement saying the regulators’ critique was “sophomoric and riddled with embarrassing errors.”

The FDIC fund in 1991 had $16 billion in reserves for losses. During the next six years (1992-1997) the FDIC determined that $13.7 billion of these reserves were not needed and reversed them. The authors of the infamous study were wrong by a whopping $113.7 billion!!

Based on my personal experience with the FDIC’s loss reserves, they are almost always high. The methodology has since changed, but when I headed the agency the estimates came from the bottom up. The people in charge of resolving a bank failure estimated the probable loss and always put it on the high side, so they did not have to explain later why the losses were higher than they told us. Those estimates tended to be increased at each review point until they reached the Chairman’s office.

For example, the estimated loss on the 1984 Continental Illinois transaction was set at $1.8 billion. The actual loss came in at $1.1 billion. More recently, the estimated losses for Colonial Bank and AmTrust Bank, two large failures in 2009, were billions higher when the banks were added to the problem bank list than the estimated losses after they failed and were sold.

During my time at the FDIC, it created reserves only for failed banks. In 1988 the FDIC began reserving for both failed and problem banks. The reserves are based on methodology developed by the FDIC in accordance with Generally Accepted Accounting Principles and approved by the Government Accountability Office.

The methodology takes into account the types of assets in each bank and the bank’s probability of failure. It should be noted that only about 25% of banks designated as problem banks actually fail.

I am not a fan of applying GAAP accounting to the FDIC – not because it tends to understate probable losses but because it tends to overstate them. Worse yet, GAAP accounting in the context of the FDIC (and in the case of bank loan loss reserves) is highly pro-cyclical.

The models for reserves look backward. Banks and the FDIC cannot set aside adequate reserves for losses in good times because they cannot demonstrate the probability of losses with mathematical precision. Conversely, in bad times the backward looking models have an insatiable appetite for additional reserves.

I give the FDIC and its current Chairman Sheila Bair high marks for being forthcoming throughout this crisis. They call things as they see them and do not sugar coat the news.

I have a proposition for the pundits who are so concerned about the adequacy of the FDIC’s reserves. I will bet you a dinner at a fine restaurant that the FDIC’s current $40 billion of reserves for losses will prove too high and some portion of the reserves will be reversed during the next five years.