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By Robert Prechter

The following article is an excerpt from Robert Prechter’s Elliott Wave Theorist. For more information from Robert Prechter on bank safety, download his free report, Discover the Top 100 Safest U.S. Banks.

Perhaps the single greatest reason for the unbridled expansion of credit over the past 50 years is the existence of the Federal Deposit Insurance Corporation, another government-sponsored enterprise created by Congress. The coming rush of bank failures is an outcome made inevitable the very day that Congress created the FDIC. The reason is that the creation of the FDIC allowed savers to believe that their deposits at banks are “insured” against loss.

But the FDIC is not really an insurance company. No enterprise, absent fraud, could possibly insure all the banking deposits in a nation. Nor does the FDIC do so, despite its claims. The FDIC is like AIG, the company that sold too many credit-default swaps. It contracted for more insurance than it could pay upon. Because depositors believe the sticker on the door of the bank, they have abdicated their responsibility to make sure that their banks’ officers handle their deposits prudently. This abdication allowed banks to lend with impunity for decades until they became saturated with unpayable debts.

Today, most banks are insolvent, and the FDIC is broke. This condition is deflationary for three reasons: (1) Banks are coming to realize that the FDIC cannot bail them out in a systemic crisis, so they have become highly conservative in their lending policies, as described above. (2) The main way that the FDIC gets its money is to dun marginally healthy banks for more “premiums” (meaning transfer payments) to bail out their disastrously run competitors. The more money the FDIC sucks out of marginally healthy banks, the less money those banks have on hand to lend, which is deflationary. (3) The banks that have to cough up all this money will become more impoverished at the margin, so banks that otherwise might have survived a credit crunch will be thrown even closer to the brink of failure. This is another deflationary risk.

A friend of mine whose family owns a bank told me that the FDIC recently raised its 6-month assessment from $17,000 to $600,000. In the FDIC’s latest announcement, it is considering requiring banks to pre-pay three years’ worth of “premiums,” i.e. triple the normal annual fee in a single year. It will be a miracle if the money lasts through 2010. When these funds are gone, the FDIC will have two more options: to issue its own bonds and pressure banks to buy them; and to tap its “credit line” of up to half a trillion dollars with the U.S. Treasury. It’s the same old solution: take on more new debt to back up failing old debt. More debt will not cure the debt crisis.

Meanwhile, the FDIC is contributing to the deflationary trend. It has “tightened rules on required capital levels,” which forces banks’ loan ratios to fall; and it has “extended its extra monitoring of new banks from the first three years of operation to seven years” (AJC, 11/19), meaning that banks will now have to wait four additional years before they can go crazy with loans.

For more information from Robert Prechter on bank safety, download his free report, Discover the Top 100 Safest U.S. Banks. You’ll learn how to find a safe bank, the critical difference between lending and banking, tips on international banking, and more.