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March 17, 2023

Breakingviews: Deposit insurance is addiction not medication

by Breakingviews.

Deposit insurance is as American as apple pie, and twice as unhealthy. After Silicon Valley Bank and Signature Bank failed over the weekend, Uncle Sam swept in, promising to pay back all of their customers. That move may have prevented a wave of copycat bank runs. But the idea of bailing out savers without limit is both unworkable and unhelpful.

Risk-free banking for most households is the norm almost everywhere, but it’s a recent invention. Save for the United States, which kicked off the trend in 1933, most countries only launched formal deposit guarantees within the last 50 years. Britain joined the club in 1979, and Europe mandated coverage for member states’ banks in 1994. China was a latecomer in 2015. New Zealand is one of the few holdouts, though a scheme is working its way through parliament.

The main charm of deposit guarantees is that they reduce the risk of bank runs. The failure of SVB Financial highlighted the weakness in that thinking. Bank deposits in the United States are guaranteed up to $250,000, and over 90% of SVB’s accounts held more than that sum. It’s a widely shared vulnerability. Around $7 trillion of all U.S. deposits are uninsured, 40% of the total. Thirty years ago it was less than 20%.

SVB’s customers weren’t entirely wrong to flee when they sensed danger. When a bank fails the Federal Deposit Insurance Corp, which backs savers using funds raised from a levy on the banking industry, usually steps in and finds a buyer to take on depositors of all sizes. But not always. The Washington Federal Bank for Savings, which failed in 2017, left uninsured depositors high and dry. Even today, only 42% of claims have been paid back, according to the FDIC.

Though the FDIC has only promised to make SVB and Signature’s customers whole, the idea that it has set a template for the industry helped take the heat out of the crisis. The question is what happens next. At some point, the authorities will have to spell out their position. There are broadly three choices they could make.

One is to try and throw a bigger and more permanent protective net around savers. When the financial crisis struck in 2008, the FDIC heroically pledged to back all deposits in non-interest bearing accounts that weren’t already covered. It can’t do that this time. The Dodd-Frank Act of 2010 restricts the FDIC to offering unlimited guarantees to depositors of an individual bank, which must be in receivership. FDIC boss Martin Gruenberg could still team up with Treasury Secretary Janet Yellen and Federal Reserve Chair Jay Powell to propose blanket insurance if their agencies agreed a crisis was afoot, but they would need Congressional approval, which they almost certainly would not get. They would also need to overhaul regulation to make sure even smaller banks could fail without hitting depositors.

Alternatively, regulators could invite the market to provide a solution – say, with privately funded insurance for deposits over the guaranteed limit. Massachusetts has that already, though its banks are small. Germany too enjoys unlimited insurance courtesy of a club of private banks. If U.S. lenders or their customers were prepared to pay a fair price to make deposits run-proof, maybe a consortium of financiers could step in. The FDIC discussed that possibility back in 2007, but concluded that a scheme of that type would probably need some kind of government backstop.

The trouble is that deposit insurance is like Novocaine – the higher the dose, the more the patient becomes numb. SVB’s wealthy clients already turned a blind eye to the bank’s fickle funding and losses in its investment portfolio. If they knew their deposits were riskless, they would have been even more supine. Conversely, if SVB’s managers believed their patrons could flee, they might have been more careful about loading up on long-dated securities they couldn’t easily sell.

For that reason the best option is probably to do nothing – or better still, lower the deposit insurance limit. That might seem cruel. Deposit guarantees, with their aura of protecting the small saver, have a folksy appeal reinforced by the cinematic lesson in banking that is “It’s a Wonderful Life.” But most Americans have far less than $250,000 in their bank. At JPMorgan the average insured deposit is just $7,000.

For tens of millions of customers, the $250,000 limit is a benefit they do not need, but still help fund. Lenders must pay a levy to the FDIC to cover future payouts, a sum that rose this year because the fund is understocked. The fee is calculated not just on insured deposits but on all of its liabilities. Like any cost, bankers have an incentive to offset that through fees to customers, which tend to fall hardest on low-income households. Lowering the limit therefore ought to appeal to both small-government Republicans and progressive Democrats.

With savers and investors jittery, regulators will need to tread carefully. It’s hard to get uninsured depositors to understand the dangers they face. If SVB’s venture capital and technology startup customers were oblivious to the risks, others are unlikely to be more vigilant. And if savers find themselves on the hook for small banks’ losses, funds will fly to larger lenders like JPMorgan and Bank of America, or migrate to non-banks like money market funds. Over time, though, that’s preferable to the false pretense that uninsured funds are safe come hell or high water.

Once the smoke has cleared, the healthiest thing would be to cut the 90-year riskless-banking convention down to size. After all, the U.S. system is an outlier in its generosity. Canada’s insured limit is $73,000, one-third that of its neighbor, even though the two countries’ bank balances per capita are the same. Britain’s limit is $100,000, as is Switzerland’s. The FDIC used to cap insurance at the same level, but raised it during the 2008 financial crisis. In setting the bar too high, the architects of U.S. finance have made banking more risky, and less fair.

(This item has been updated to correct the level of uninsured deposits in first graphic.)

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