If banks want more deposit insurance, they should pay for it

Treasury Secretary Yellen speaks at the American Bankers Association Summit

Janet Yellen, US Secretary of the Treasury, speaks at the American Bankers Association Washington Summit on Tuesday, March 21, 2023 in Washington, DC, United States. Yellen said the US government could repeat the drastic measures it recently took to protect bank deposits when smaller lenders are under threat. Credit – Al Drago-Bloomberg

It was announced on Monday that the Treasury Department is studying how to officially increase the country’s deposit insurance above $250,000 in response to the ongoing banking crisis. The news follows decisions by the Treasury Department, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) to guarantee all uninsured deposits at the failed Silicon Valley Bank and Signature Bank. Treasury Secretary Janet Yellen said in a speech on Tuesday that the Treasury Department stands ready to take similar action if other banks are at risk of collapsing.

The Unlimited Deposits Contingency Insurance is based on a simple idea: if depositors at failing banks do not incur a loss on their deposits, individuals and companies banking at other fragile banks will feel more secure in the safety of their own deposits and stop a more widespread bank walk in his tracks.

Significantly improved or unlimited deposit insurance would be a great gift for privately run banking institutions. If regulators are serious about moving forward and expanding deposit insurance, Congress must make banks pay for the privilege. Any unlimited deposit insurance scheme must be accompanied by additional regulatory reform of the regulated and unregulated banking sectors and a significant increase in the risk premiums that banks pay to the FDIC. Without action from Congress, we risk setting a new standard for crisis response that could cause more bank failures, not fewer.

Improved deposit insurance could actually help contain this current panic and prevent the next one. The stakes are not small: In the FDIC-insured banking system, uninsured deposits were $7.7 trillion at the end of last year, more than 40 percent of all deposits. A full guarantee on these deposits could make the traditional bank run a thing of the past – why leave a bank in distress when you know you’ll still have access to all your money in the event of a default? It would make it clear that we should not expect depositors, whether individuals or small businesses, to closely monitor the financial health of the bank they use. The guarantee could also make it easier for larger companies to manage cash flow needs by reducing their reliance on cash-like financial products such as money market mutual funds or insured cash-sweep accounts that spread money across many banks to get within the current $250,000 Dollar to stay the FDIC limit.

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The story goes on

Why was there no unlimited deposit insurance until now? Banks serve public purposes—credit and money-making—but are motivated by private-sector goals of financial gain. A deposit guarantee would change this relationship meaningfully by giving the banks a new advantage, namely a much more stable deposit base. Politicians and economists alike are concerned about the “moral hazard” that could arise: unless banks face a run, they will use that stability to invest in riskier or less liquid assets and earn returns that boost their profits. Government deposit insurance, a public good, would be used to boost banks’ profits. If a bank fails, its stock and bondholders could be wiped out, but savvy investors would have enjoyed years of subsidized returns before the collapse.

READ ALSO: Who Is Really To Blame For The Collapse Of Silicon Valley Bank?

One way to prevent this would be to limit the risks that banks could take, particularly by tightening existing regulation, including capital and liquidity requirements. Banks provide important financial services because governments give them exclusive powers to convert short-term liabilities into longer-term assets. If a critical liability, deposits, is to be made resilient, we should expect banks to hold more cash in case a crisis hits and depositors want their money back. The largest too big to fail banks are already facing heightened demands due to governance changes in the years following the Great Financial Crisis of 2008-2009. But in 2018, Republicans in Congress, along with a handful of Democrats, rolled back those requirements for most banks, one of the main reasons we are facing today’s crisis.

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Additionally, Congress would need to tie unlimited deposit insurance with significantly higher fees to the FDIC for deposit insurance. These should be carefully linked to a bank’s leverage to ensure that the riskiest banks pay the most for the insurance enjoyed by their depositors.

Tighter regulation of this kind could have problematic side effects, particularly limiting banks’ ability to lend to borrowers. Firms looking for credit in many cases have an alternative to the traditional banking sector: the network of hedge funds, private equity funds and investment banks that make up the so-called “shadow banking” sector (ie big financial firms like Blackrock and Apoll). Almost all major financial institutions touch the unregulated world of shadow banking in some way through their borrowing and lending. For example, if a company in need of funds sells an asset with the promise of buying it back shortly thereafter, the repurchase agreement entered into establishes a short-term lending relationship. Most of the time, these agreements can be renewed or “rolled over,” creating a bank-like banking relationship. This is functional banking, but most importantly without the need for a banking charter.

Estimates of the size of the sector vary due to the lack of comprehensive reporting requirements, but the Financial Stability Board, a global body that oversees the financial system, puts the size of US non-bank financial intermediation at $20 trillion, about 15 percent of American financial wealth.

Despite the name, shadow banking is not inherently nefarious; Much of the activity can improve the functioning of financial markets. Money market funds, for example, allow millions of Americans to earn a return on cash-like deposits by giving them access to high-yield financial products that would otherwise be difficult to access. This is particularly important in times of high inflation. Similarly, repurchase agreements create helpful liquidity for large companies that need near-term cash or for those interested in using their excess cash to generate a modest return.

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The problem is that shadow banks are not subject to the same regulatory requirements as traditional banks, but enjoy an effective public guarantee. When crises arise, the Federal Reserve steps in in concert with the other government agencies to provide systemic insurance, as they did in 2008, 2020, and again this month. The Fed even now uses its own repo facilities as its primary method of implementing monetary policy. When a crisis hits, we know that the US government will support the institutions involved in banking-like activities even if they were not previously properly regulated. The shadow banks thus have the opportunity to operate bank-like financial activities without the regulatory requirements of traditional banks.

Unlimited deposit insurance and higher capital and liquidity ratios, desirable as they may be, could inadvertently push more funds into this largely unregulated money market and create more instability, not less. Investors often find ways to circumvent rules to achieve outcomes similar to those the government was trying to control. As new laws require regulated banks to pay for the privilege of unlimited deposit insurance, shadow banks will need to step into the regulatory arena to ensure they don’t become places of increasingly risky behavior.

Policy makers today must simultaneously restore depositor confidence and address the risks that unlimited deposit insurance could pose. If Congress does nothing, unlimited deposit insurance guarantees will likely be reinstated in the next crisis, setting a dangerous precedent and ignoring the risks to financial stability.