Personal Wealth Management / Politics

On America’s Deposit Insurance Debate

Rushing to “fix” something can send weird messaging.

Editors’ Note: MarketMinder favors no political party nor any politician. We assess political developments for their potential economic and market impact only.

Every now and then, America’s congressmen and women try to put aside partisan differences to “help” during a perceived crisis. They are debating doing so now on the topic of uninsured bank deposits, as people remain concerned that large deposits’ flight could destroy regional banks. Some have proposed permanently lifting the FDIC’s $250,000 deposit insurance cap on all deposits. Others favor raising or suspending the cap temporarily for businesses’ transaction accounts—meaning, accounts used to process payroll and other operating expenses and receive sales. Some argue this is necessary to keep businesses from fleeing—and therefore to save—regional banks. Others warn raising the cap will destroy banks’ incentives to manage risk, setting up a big meltdown in the future. We find problems with both viewpoints: We don’t see evidence of some systemic run on small banks, and we don’t think raising the limit alters bank management’s incentives. However, we do see some potential drawbacks in the messaging that we think are worth considering.

Yes, this is another commentary stemming from Silicon Valley Bank’s (SIVB) failure and its continued fallout. Sorry. But there are loose threads worth addressing here. When SIVB entered receivership, according to the FDIC’s standard procedures, customers would have full access to deposits under $250,000, but anything above that would have been locked up until the bank’s assets were liquidated and the proceeds distributed to claimants. This process can take years, and accountholders often receive less than their full deposits. Unsurprisingly, this outcome was unpalatable to SIVB’s customers, who were predominantly venture capital (VC) funds and partners, their portfolio companies, and the companies’ and funds’ employees, family and friends. Thus began a full-court press for the Fed and Treasury to cover the “small businesses” that banked there. They argued blocking access to uninsured deposits would prevent local employers from making payroll, with devastating consequences for the proprietors and employees alike. They continued to suggest that if deposits weren’t 100% guaranteed, small banks nationwide could face runs.

In reality, there is a lot of evidence that many of these companies were VC-funded startups burning through cash because of either flawed business models or economic conditions. Those with viable businesses would likely have been able to get another funding round, and those without them probably would have failed anyway. But early investors hate getting diluted, hence the campaign to bail out customers. It worked, and the authorities guaranteed all deposits—insured and uninsured—at SIVB and Signature Bank, which failed just after SIVB.

In the financial world, there is a concept called “moral hazard.” That refers to the potential for bailouts to distort incentives and thus discourage businesses from limiting risk. You may remember seeing that phrase a lot in 2008, and it came up again when SIVB failed: To limit moral hazard, the Fed and Treasury stressed they were guaranteeing uninsured deposits at these two institutions only.

This messaging created a pickle. One, it extended nervousness about uninsured deposits at other lenders. Two, it created the perception that scrapping deposit insurance limits really would create moral hazard. People soon conflated bailing out the depositors with bailing out the bank itself, forgetting that all shareholders still took massive losses. They mistook a bailout of Silicon Valley for a bailout of its favorite bank. Meanwhile, Congress clearly bought the narrative that SIVB’s clients were archetypal American small businesses, like a small-town dentist, ma-and-pa run shop or general store, and now some lawmakers have decided they must save allegedly similar businesses and banks nationwide.

In our view, this ignores the role VCs played in this saga. The run on SIVB began when VCs instructed their portfolio companies to pull their deposits from SIVB before everyone else did. The problem wasn’t that SIVB had a glut of uninsured deposits, but that its balance sheet wasn’t equipped to handle its business clients drawing down deposits to fund operating expenses last year. It didn’t have sufficient liquidity to handle their high cash burn rates, and its startup loan portfolio wasn’t exactly rock-solid given the industry’s well-documented problems. It also had far more long-term US Treasury bonds than other banks, leaving it extra-exposed when long-term interest rates rose—and forcing it to realize big losses when it sold these securities to support the ongoing withdrawals. It was a series of problems that a bank whose customer base was concentrated in the Silicon Valley startup world was especially exposed to. None of it is analogous to, say, your average regional bank. Those institutions actually are operating the way social media tried to portray SIVB, and Fed data from last week indicate they aren’t bleeding deposits. They also appear to be using the discount window and a new Fed liquidity program to shore up their coffers just in case, indicating the system is working as intended for now. Perhaps the next round of bank deposit data, due Friday, will show more stress, but for now the talk seems greater than the reality.

So we aren’t convinced temporarily raising or suspending the FDIC insurance cap for savers or businesses is necessary. But we also don’t think doing so creates a Wild West where banks throw caution to the wind to offer savers high rates. We agree banks aren’t charities and are profit-motivated. But to earn a profit, you have to stay in business. SIVB’s deposits may be 100% accessible, but the business is going to die. Its stock is at zero. Executives took a bath on their equity and stock options. And there is unquantifiable reputational damage for those persons involved. In our view, these factors greatly limit moral hazard. Bank execs nationally see and understand this and know full well that government guaranteeing deposits doesn’t save them from the consequences of bad decisions.

With all of this said, if the rush to increase deposit insurance caps gains traction in Congress, we think it risks sending the wrong messages. Chiefly, it perpetuates the view that there is a deep problem requiring a quick solution. That could extend uncertainty and create more panic, much as the Fed’s initial efforts seemed to do last week. When you act like there is a big problem, some people will act accordingly, and it risks being a self-fulfilling prophecy. Not that it would create a bank run, but more volatility in regional bank stocks wouldn’t surprise.

More broadly, it would extend the long-running confusion over how the authorities treat uninsured deposits. The history on this front, which is documented in a great FDIC research report from 2020, is a bit haphazard. From 1980 – 1987, as the savings & loan crisis slowly built, uninsured depositors took at least some losses in 24% of bank failures. In 1988 – 1991—the peak crisis years—most failing banks entered purchase and assumption agreements, whereby a stronger bank bought them out and assumed all deposits, insured and uninsured. As a result, only 14% of bank failures imposed losses on uninsured depositors during those years. But a 1992 regulatory change ended the practice of “purchase and assumption without loss share,” meaning in most cases, the purchasing institution wouldn’t take on the uninsured deposits. Therefore, between 1992 and 2007, uninsured depositors took losses in a whopping 65% of bank failures. This brings us to 2008, when sheer panic during the global financial crisis led to the deposit insurance cap’s increase from $100,000 to $250,000 and the temporary suspension of insurance limits for businesses’ transaction accounts. This, plus the decision to protect Washington Mutual’s uninsured depositors when JPMorganChase bought it from FDIC receivership, limited uninsured deposit losses to just 28% of bank failures in 2008 and 6% from 2009 – 2013.[i] In a 2008 FAQ on the WaMu acquisition, the FDIC summed up the perceived inconsistencies thusly: “The FDIC is required by law to employ the least-cost resolution measure for each failed financial institution. … The most frequent result is for the FDIC to transfer only the insured deposits in a merger transaction. The FDIC has been able to transfer all deposits in about 25% of the failures over the past 15 years.”[ii]

Temporarily protecting uninsured deposits in 2008 and again in 2020 creates the perception that this is necessary in a crisis—the only thing preventing a bank run. In other words, the recent history of creating winners and losers sets expectations that officials will … create winners and losers. It is all a bit arbitrary, in our view. We suspect that rather than rush through a change now, a better approach would be to carefully consider what the permanent system should be, enshrine it and then stick to it. Heck, we would apply that logic to bank regulation entirely, rather than the current approach of taking special crisis actions whenever crisis strikes. As we have written many times over the years, creativity isn’t a desirable trait in regulators. Markets like consistency and predictability, not the uncertainty of snap decisions and temporary solutions. 

But we don’t live in an ideal world. We live in a world where political incentives motivate Congress to act fast, lest voters tar and feather them for not doing anything. If tweaking deposit insurance caps is all they do, that is probably about as benign an outcome as you could hope for—it beats a wholesale regulatory review and update a la Dodd-Frank in 2010. But don’t be surprised if more volatility accompanies it, and understand that it is largely just windowdressing.

[i] “FDIC Resolution Tasks and Approaches: A Comparison of the 1980 to 1994 and 2008 to 2013 Crises,” Lynn Shibut and George de Verges, Federal Deposit Insurance Corporation Staff Studies, Report No. 2020-05.

[ii] “Question and Answer Guide: Washington Mutual Bank, Henderson, NV and Washington Mutual Bank, FSB, Park City, UT,” FDIC, last updated 3/26/2015.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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