Insuring all bank deposits is a manageable expense

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A group of conservative Republican officials known as the House Freedom Caucus last week opposed any proposal that would remove the deposit insurance cap, currently set at $250,000. Members of the US Congress on both sides of the aisle are understandably wary of taking such a dramatic step in the midst of an unfolding crisis. But while it would be a mistake for lawmakers to attempt to fix the current instability in the banking sector with hastily drafted legislation, it is clear that any solution must include legislation providing comprehensive insurance for all retail deposits in the US.

Undoubtedly, expanding deposit insurance without additional risk to taxpayers will require a significant increase in Federal Deposit Insurance Corp reserves. But there is a precedent. During the financial crisis of 2008 and 2009, the FDIC went well beyond what was necessary to ensure deposit safety when it used its own funds to partially protect uninsured depositors at large institutions like IndyMac. The logic was that it would be cheaper to protect all depositors at big too-big-to-fail banks than to allow a general banking panic that could trigger a run on dozens of other financial institutions with partially guaranteed deposits.

Still, having this kind of quasi-guarantee without charging banks a backstop fee was seen by many as unfair, inefficient and systemically risky for uninsured depositors. The Dodd-Frank Act helped solve this problem by requiring banks to measure deposit insurance fees based on total liabilities and not just insured deposits. But simply changing the formula still leaves some issues unaddressed. First, while all banks pay fees based on their total liabilities, only large banks receive an implicit guarantee on all deposits. This is not only unfair, but even encourages runs on medium-sized banks, most notably Silicon Valley Bank.

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When depositors became even a little worried about the health of Silicon Valley Bank, they didn’t withdraw their money in the form of physical cash or invest it entirely in gold coins. They simply transferred the money to an account at a large, too-big-to-fail bank. This process has become so quick and easy that there is no longer any incentive for a depositor to carefully scrutinize a bank’s health. This is the opposite of what deposit insurance is supposed to achieve. However, that is exactly what is to be expected in a system that only gives implicit guarantees to the largest banks and not an explicit guarantee on all deposits for all banks.

The underlying logic behind setting a deposit insurance cap is that it encourages the largest and most experienced depositors to keep an eye on a bank’s risk management. In theory yes, but Silicon Valley Bank and Signature Bank show that this is not the case in practice. Tech companies with tens of millions of dollars deposited at Silicon Valley Bank seem unaware of the risks. Even in theory, it would be unreasonable to think that depositors have enough financial savvy to appreciate the kind of bond market risk that Silicon Valley Bank has undermined. Even to the most seasoned depositors, the bank’s decision to invest in US Treasuries when it could not find suitable loans seems like a responsible decision.

Moreover, the fundamental error – assuming that government bond yields accurately reflect maturity risk – was one committed by many leading economists, including those in the Federal Reserve. Very few economists anticipated persistent inflation ahead of 2022, which would require the most aggressive rate hikes in history. It was these rate hikes that drove down the value of Silicon Valley Bank’s Treasury holdings. Indeed, as its bonds fell in value, it made sense for Silicon Valley Bank to hold them, since a sale at a loss would have created – and ultimately did – the kind of crisis of confidence that brought the bank down.

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And while there is an implicit guarantee on at least some uninsured deposits, the FDIC has historically only charged enough aggregate fees to cover insured deposits. As a result, the FDIC ran out of funds during the last financial crisis and has been chronically underfunded ever since. The FDIC increased the base rate it charges banks from three basis points to five basis points, or 0.05 percentage point. To adequately cover the entire $18 trillion US deposit base, the FDIC would need to hold about twice the funds of the current $10 trillion insured deposit base. This would require a further increase in the FDIC base rate to about 9 basis points to 10 basis points.

According to a previous FDIC analysis, a surge of this magnitude is enough to lose a significant chunk of bank profits of around 6%. Still, it’s less than the impacted regional banks brought to their share prices shortly after Silicon Valley Bank. It’s also roughly the percentage of profit banks paid for deposit insurance in 2011 — an extra burden, but one that’s very manageable.

To reduce risk to taxpayers, level the playing field between small and large banks, and reduce the likelihood of bank runs in general, Congress should officially extend the FDIC’s guarantee to all bank deposits and increase fees to reflect actual risks adjust which are insured. Some in Congress are concerned that a blanket guarantee would encourage risk-taking, but sticking with the current two-tier quasi-guarantee is the biggest risk of all.

More from the Bloomberg Opinion:

• No, it’s not like 15 years ago. What matters is 25: John Authers

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• Past Fed banking crises warn for Powell: Niall Ferguson

• You know whose deposits are not safe? The bankless: Claudia Sahm

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

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