Deposit insurance is addiction, not medication

NEW YORK, March 16 (Reuters Breakingviews) – Deposit insurance is as American as apple pie and twice as unhealthy. After Silicon Valley Bank and Signature Bank (SBNY.O) failed over the weekend, Uncle Sam walked in and vowed to pay back all of their customers. This move may have prevented a wave of copycat bank runs. But the idea of ​​saving savers indefinitely is neither feasible nor helpful.

Risk-free banking for most households is the norm almost everywhere, but it’s a new invention. Apart from the United States, which started the trend in 1933, most countries have only introduced formal deposit insurance in the last 50 years. Britain joined the club in 1979 and Europe mandated cover for member states’ banks in 1994. China was a laggard in 2015. New Zealand is one of the few holdouts, although a program is making its way through Parliament.

The main appeal of deposit insurance is that it reduces the risk of bank runs. The collapse of SVB Financial (SIVB.O) has highlighted the weakness of this thinking. Bank deposits in the United States are guaranteed up to $250,000 and over 90% of SVB accounts held more than that amount. It’s a common vulnerability. Around $7 trillion of all US deposits are uninsured, 40% of the total. 30 years ago it was less than 20%.

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Not without good reason, SVB customers fled when they sensed danger. When a bank fails, the Federal Deposit Insurance Corp, which supports savers with funds derived from a banking sector levy, usually steps in and finds a buyer who will take depositors of any size. But not always. The Washington Federal Bank for Savings, which went bust in 2017, left uninsured depositors dry. Even today, only 42% of claims have been paid, according to the FDIC.

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Although the FDIC has only promised to bring SVB and Signature customers back to health, the idea that it 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 take a stand. There are broadly three possibilities that they could meet.

One is to try to cast a larger and more permanent safety net around savers. When the financial crisis hit in 2008, the FDIC heroically promised to protect all unfunded deposits in interest-free accounts. It can’t this time. The Dodd-Frank Act of 2010 limits the FDIC to offering unlimited guarantees to depositors of a single bank that must be in receivership. FDIC chief Martin Gruenberg could still join forces with Treasury Secretary Janet Yellen and Federal Reserve Chair Jay Powell to propose blanket insurance if their agencies agree a crisis is underway, but they would need congressional approval if which they almost certainly would not receive. They would also need to overhaul regulation to ensure even smaller banks could fail without hitting depositors.

Alternatively, regulators could ask the market to offer a solution – for example, privately funded insurance for deposits over the guaranteed limit. Massachusetts already has, although its banks are small. Germany also has unlimited insurance thanks to a club of private banks. If US lenders or their customers were willing to pay a fair price to make deposits safe, perhaps a consortium of financiers could step in. The FDIC discussed this possibility back in 2007, but concluded that a system of this type would likely need some sort of government backing.

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The problem is that deposit insurance is like novocaine – the higher the dose, the more drugged the patient. Already, SVB’s wealthy clients have turned a blind eye to volatile funding and losses in their investment portfolio. If they had known their deposits were risk-free, they would have been even more cautious. Conversely, had SVB managers believed their clients might flee, they might have been more cautious about loading long-dated securities that they could not easily sell.

For that reason, doing nothing — or even better, lowering the deposit insurance limit — is probably your best option. That may seem cruel. Deposit insurance, with its aura of protecting the small saver, has a folksy appeal that’s reinforced by the cinematic banking doctrine It’s a Wonderful Life. But most Americans have far less than $250,000 in their bank. At JPMorgan (JPM.N), the average insured deposit is just $7,000.

For tens of millions of customers, the $250,000 limit is a benefit they don’t need but still help fund. Lenders are required to pay a levy to the FDIC to cover future payouts, a sum that rose this year because the fund is understaffed. The fee is charged not only on insured deposits, but on all of their liabilities. As with all costs, bankers have an incentive to offset these through fees to customers, which tend to hit low-income households the hardest. So lowering the limit should appeal to both small-government Republicans and progressive Democrats alike.

With savers and investors nervous, regulators need to tread carefully. It is difficult to get uninsured depositors to understand the dangers they face. While SVB’s venture capital and tech startup clients were unaware of the risks, others likely won’t be more vigilant. And when savers are on the brink of small bank losses, funds will flow to bigger lenders like JPMorgan and Bank of America (BAC.N) or to non-banks like money market funds. Over time, however, that is preferable to the false claim that uninsured funds are safe when all hell or high tide comes.

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Once the smoke clears, the healthiest thing would be to pare down the 90-year convention of risk-free banking to a minimum. After all, the US system is an outlier in its generosity. Canada’s insured limit is $73,000, a third that of its neighbor, even though the two countries have equal bank balances per capita. Britain’s limit is $100,000, as is Switzerland’s. The FDIC used to set the insurance cap at the same level, but raised it during the 2008 financial crisis. By raising the bar too high, the architects of US finance have made banking riskier and less fair.

Reuters graphics

(This story has been corrected to change the amount of uninsured deposits in the first chart.)

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Editing by Peter Thal Larsen and Amanda Gomez

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