Karl W. Smith: Insurance for all bank deposits is a manageable cost

Karl W. Smith, Bloomberg Opinion on

Published in Business News

A group of conservative Republicans representatives known as the House Freedom Caucus came out last week against any proposal that would lift the cap on deposit insurance, currently set at $250,000. Members of U.S. Congress on both sides of the aisle are understandably cautious about taking such a dramatic step in the middle of an unfolding crisis. But although it would be a mistake for lawmakers to try to repair the current instability in the banking sector with hastily drafted legislation, it’s becoming clear that any solution needs to include legislation providing comprehensive insurance to all retail banking deposits in the U.S.

No doubt, expanding deposit insurance without placing additional risk on taxpayers will require a substantial increase in reserves held by the Federal Deposit Insurance Corp. But there is precedent. During the financial crisis of 2008 and 2009, the FDIC went well beyond what was necessary to ensure the safety of deposits when it used its own funds to partially cover uninsured depositors at large institutions such as IndyMac. The logic was that it would be cheaper to ensure all depositors at large, too-big-to-fail banks than to allow a general banking panic, which could induce runs on dozens of other financial institutions with partially guaranteed deposits.

And yet, it was seen to many as unfair, inefficient and systemically risky for uninsured depositors to have this sort of quasi-guarantee without banks being charged a fee for the backstop. The Dodd-Frank Act went part of the way in solving this problem by requiring banks be assessed deposit insurance fees based on total liabilities rather than just insured deposits. But simply changing the formula still leaves several problems unaddressed. First, while all banks pay fees based on their total liabilities, it is only large banks that receive an implicit guarantee on all deposits. This is not only unfair, but actually encourages runs on medium-sized banks, with Silicon Valley Bank being a prime example.

When depositors became even slightly worried about the soundness of Silicon Valley Bank, they didn’t pull their money out in the form of physical cash or invest it all in gold coins. They simply wired the money to an account at a large, too-big-to-fail bank. This process has become so fast and easy that there is no incentive for a depositor to conduct due diligence on a bank’s health. This is the opposite of what deposit insurance is supposed to achieve. Yet, it’s precisely what should be expected in a system that gives implicit guarantees to only the largest banks rather than an explicit guarantee on all deposits to all banks.

The underlying logic of putting a cap on deposit insurance is that it incentivizes the largest and most sophisticated depositors to keep an eye on a bank’s risk management. In theory, yes, but Silicon Valley Bank and Signature Bank show that’s not what happens in practice. Tech companies with tens of millions of dollars deposited at Silicon Valley Bank were seemingly oblivious to the risks. Even in theory it would be unreasonable to think depositors have a deep enough understanding of finance to appreciate the type of bond market risk that undermined Silicon Valley Bank. To even the most sophisticated depositors, the bank’s decision to invest in U.S. Treasury bonds, when it couldn’t find suitable loans, seems like a responsible decision.

Moreover, the fundamental mistake – assuming that Treasury yields accurately reflected term risk – was one that many leading economists, including those at the Federal Reserve, made. Very few economists anticipated persistent inflation that would require the most aggressive series of interest-rate hikes in history as a strong possibility before 2022. It was those rate hikes that drove down the value of Silicon Valley Bank’s holdings of Treasuries. Once its bonds declined in value it was actually prudent for Silicon Valley Bank to hold on to them, as selling them at a loss would have — and eventually did — precipitate the very type of crisis of confidence that brought the bank down.

And even though there is an implicit guarantee on at least some uninsured deposits, the FDIC historically only levied enough in total fees to cover insured deposits. This caused the FDIC to deplete its funds during the last financial crisis and it has been chronically underfunded ever since. The FDIC did increase the base rate it charges banks from three basis points to five basis points, or 0.05 percentage point. Adequately covering the total deposit base in the U.S. of $18 trillion would require the FDIC to hold roughly twice the funds needed to currently insured deposit base of $10 trillion. That would necessitate a further increase in the FDIC’s base rate to somewhere around 9 basis points to 10 basis points.


An increase of that size is enough to take a meaningful chunk out of bank profits of around 6%, according to past FDIC analysis. Yet, it’s less than the hit regional banks took to their share prices just after Silicon Valley Bank. It’s also roughly the percentage of profits that banks were paying for deposit insurance in 2011 — an added burden but one that’s eminently manageable.

In order to reduce the risk on taxpayers, level the playing field between small and large banks, and lessen the likelihood of bank runs in general, Congress should officially expand the FDIC’s guarantee to all bank deposits and increase the fees to align with the actual risks that are being insured. There are those in Congress who are worried that a blanket guarantee would encourage risk taking, but sticking with the current two-tiered, quasi-guarantee is the biggest risk of all.



Karl W. Smith is a Bloomberg Opinion columnist. Previously, he was vice president for federal policy at the Tax Foundation and assistant professor of economics at the University of North Carolina.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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