Bank failures underscore the importance of deposit insurance

Two high-profile bank failures in the last two weeks have gripped the financial sector, prompting many savers to seek reassurance that their own deposits are safe. For most people, deposits with their bank or credit union are perfectly safe, subject to certain rather high dollar limits, beyond which they can easily eliminate additional risks.

It is useful, and hopefully reassuring, to recognize the various factors that led to these dramatic defaults and how little these institutions resembled the banks where most of us keep our checking and savings accounts. In particular, the collapse of Silicon Valley Bank involved a confluence of disastrous management decisions, a significant concentration of risky customers, and an apparent failure of regulatory oversight. It’s also a good time to test how safe the US banking system remains for the average depositor.

Silicon Valley Bank, or SVB, was a California bank that catered to a concentrated and uniquely risky clientele: venture-backed startups. The bank quintupled deposits during the post-Covid boom and served as a lender to these burgeoning companies and held the substantial capital made available to them by their investors. Many customers deposited millions of dollars with SVB, even though the accounts were only insured up to $250,000, with the rest at risk in the event of the bank’s insolvency. At most commercial banks, most deposits fall under the FDIC limits. Almost 90% of SVB deposits were uninsured.

This error was attributable to depositors. What came next was a catastrophic management failure. Aware that deposits could be withdrawn at any time, the SVB still attempted to make profits by investing the deposits in long-dated government and mortgage securities, literally betting that interest rates would stay low forever.

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As the Fed embarked on the most aggressive relative cycle of rate hikes in history, the market value of the bank’s bond holdings fell. Meanwhile, venture capital flows have all but dried up, forcing startups to tap into their deposit accounts. To meet liquidity needs, SVB had to sell $20 billion worth of bonds at distressed prices while announcing its intention to raise additional capital. Sensing the danger, depositors called for withdrawals, while the bank’s CEO asked investors and customers to “keep calm and don’t panic”. That’s cryptic banking argot for “get out of Dodge.”

The result was a bank run that forced California regulators to freeze assets and appoint the FDIC as receiver. Over the weekend, the FDIC, Federal Reserve and Treasury Department used their emergency powers to step in and support uninsured depositors with FDIC insurance funds. The Fed has also created a special line of credit that allows banks to pledge their high-quality but weak Treasuries as collateral for short-term borrowing, giving them time to raise new equity. The plan has been criticized for taking depositors off the hook for lax risk management, but SVB investors, including shareholders and some creditors, will be wiped out. Management was fired and the plan appears to have reduced the risk of contagion significantly. Importantly, taxpayers are not on the hook for the bailout.

Notably, the collapse of SVB and the closure of crypto-related Signature Bank were swiftly dealt with and their fatal wounds were largely self-inflicted and not representative of traditional custodians that hold most families’ CDs and checking accounts.

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Understand FDIC insurance

The Banking Act of 1933 created the Federal Deposit Insurance Corporation, which originally guaranteed bank accounts up to $2,500. The limit was increased over time to $250,000 by the Dodd-Frank Act of 2012. Most credit union deposits are similarly covered by the National Credit Union Administration.

The FDIC insures deposits up to $250,000 per bank for each person and for each different category of account holder, so each person can be covered in more than one account up to the limit. For example, joint account holders are individually insured, so a married couple could have a joint account of $500,000 and be fully protected. Individual accounts, trust accounts, and some retirement accounts are also treated separately, with the $250,000 limit applying to each category. Payment on Death (POD) accounts are a type of escrow account where the limit is separate for each named beneficiary.

Balances in excess of the FDIC aggregate limits may be insured by being spread across multiple banks. Also, many institutions belong to an interbank network, which allows your home bank to hold CDs or accounts on your behalf with other member banks while maintaining the contact and reporting relationship with you.

Businesses that need cash balances in excess of the insured limit often use treasury services that handle day-to-day cash management for a small fee. It’s also relatively easy to buy short-dated US T-bills in the highly liquid next-day settlement secondary market. US Treasuries are not technically FDIC-insured but are backed by the full trust and creditworthiness of the US government.

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The Fed’s and FDIC’s aggressive response to the SVB debacle was not without its critics, but appears to have contained the risk of a broader deposit rush. A review of the defaults that triggered the collapse is already underway and will likely result in increased oversight for riskier institutions. In the meantime, the banking system remains safe and secure for the rest of us.

Christopher A. Hopkins, a chartered financial analyst, is co-founder of Apogee Wealth Partners.