After bank failures, raising deposit insurance has benefits – and risks

Sue Hackney had heard the news, of course. When reports surfaced in March that First Republic Bank might be in trouble, the Boston-area marketing professional and her husband debated whether to pull their money out. But “their customer service is so good,” she says, so the couple waited.

Then last week, the San Francisco-based bank released its quarterly earnings, which showed it had lost more than a third of its deposits. Its shares, already deeply discounted, plunged again – in all, a stunning 97% fall in value in three months.

Busy at work and two days away from a trip out West, Ms. Hackney felt in no position to suddenly find a new bank. “We also figured the FDIC insurance is there,” she says. On Monday, JPMorgan Chase – the nation’s largest bank – validated her optimism. It announced it had acquired the substantial majority of First Republic’s assets from the Federal Deposit Insurance Corp. and that First Republic’s branches would open as usual on Monday.

While the immediate drama has ended, easing fears about U.S. banks’ stability, FDIC insurance itself is under scrutiny. With three banks now felled by bank runs in the past two months, regulators are looking anew at the program that was created 90 years ago to discourage bank runs. On Monday, the FDIC released a report outlining three options. The problem is that its actions to calm markets may have foreclosed all but one of those options.

The FDIC report takes a detailed look at the pros and cons of keeping the status quo, moving to unlimited deposit insurance, or using what it calls targeted insurance. It recommends targeted insurance, where business payment accounts would receive significantly higher coverage than individual consumer accounts.

But regulators’ actions may speak louder than their words. By using a loophole in March to guarantee all deposits at the first two failed banks, regulators may be hard-pressed to walk back such a commitment in future bank failures. Up to now, the FDIC has only guaranteed bank depositors up to $250,000 per single account; $500,000 for a joint account. Many economists worry unlimited insurance would encourage risky behavior by banks and depositors, or what they call moral hazard.

“Unlimited coverage ... clearly cannot be the right answer. I mean, you can pretty much prove it,” says Eduardo Dávila, an economics professor at Yale University in New Haven, Connecticut, and co-author of a 2021 study on optimal deposit insurance. “Unlimited coverage will require enormous amounts of regulation in a way we haven’t seen in 40 years.”

Bank stock and bond holders still do face risks of failure in the marketplace, even when deposits are protected.

But the conundrum is a real one: Too little deposit insurance could encourage more bank runs. Too much would require more oversight and rules by regulators to keep banks in line.  

“They’re in a bit of a bind right now, unless all this settles down and in two months all is well,” Daniel Tarullo, an international financial regulation professor at Harvard and former member of the Federal Reserve Board of Governors, said last Wednesday in an online event at the Peterson Institute for International Economics. “Are we saying we’re giving up entirely on market discipline?”

There’s too little market discipline in banking already, says Charles Calomiris, a Columbia Business School professor and former chief economist of the Office of the Comptroller of the Currency, another federal bank regulator. Some of the regulatory reforms in the aftermath of the savings-and-loan crisis of the 1980s and the financial crisis of 2008 have increased FDIC insurance and discouraged banks and big depositors from exercising some discretion in where they put their money. The predictable result, critics say: messes like the one at Silicon Valley Bank, which in March became the nation’s second-biggest bank takeover in history until First Republic Bank replaced it Monday.

In a sharply critical report released Friday, the Federal Reserve blamed Silicon Valley Bank’s collapse on a combination of the bank’s failure to manage interest-rate risk and the Fed’s own supervisors, who delayed too long before reacting to the growing signs of trouble. Silicon Valley Bank had grown rapidly by catering to high-tech startups in need of financing and by encouraging them to keep all their money at the bank, sums that often exceeded the FDIC’s $250,000 limit.

“How in the world could there have been so much in dumb uninsured deposits sitting at one bank?” Mr. Calomiris asks. “The answer is: That’s what deposit insurance did, ironically,” along with other regulatory changes.

In a separate report also released Friday, the FDIC blamed the failure of Signature Bank on mismanagement and said, in retrospect, its staff could have acted sooner. The bank also specialized – in this case, in the New York real estate market – and in 2018 began allowing customers with at least $250,000 on deposit to use cryptocurrency, a digital kind of money. As a result, many of its clients had accounts well above the FDIC limit.

First Republic was also heavily involved in real estate, offering jumbo mortgages to wealthy homeowners on the East and West coasts. When rumors of big withdrawals at Silicon Valley Bank began to circulate, fears about Signature and First Republic spread, leading many of their depositors to pull money out.

The underlying problem that exposed the flaws at these three banks is endemic to most banks to some extent. They make long-term loans, such as mortgages, but pay money out on short-term deposits. When interest rates on those deposits rise dramatically, banks can end up paying out more money on deposits than they’re making on loans, and their profits get squeezed. The 4 percentage point rise in interest rates in the past year has been the fastest since the 1980s. 

Clearly, all three banks were operating without much of a safety net. The big question for regulators is whether those banks were the exception or whether regulators need to extend the safety net so other banks don’t come under pressure.

Monday’s FDIC report points to several trends that may be making the banking system more vulnerable to runs, such as the power of social media to quickly spread concerns about specific banks. Another problem is the rapid growth of uninsured deposits after the financial crisis, which grew from $2.3 trillion at the end of 2009 to $7.7 trillion in 2022. The problem is especially acute among the top 1% of banks, where just under a third of deposits were uninsured compared with 14% before 2020. 

That means that a small group of big customers may quickly spark a panic. “Growing concentrations of uninsured deposits at large banks make the banking system potentially more vulnerable to depositor runs,” the FDIC report said.