The ‘moral hazard’ of a higher federal insurance limit on US bank deposits

PLANS to vastly expand the Federal Deposit Insurance Corporation (FDIC)‘s safety net restored investor confidence in banks such as First Republic and the US stock market this week, but these moves could well stall or even backfire.

The current banking crisis, as Treasury Secretary Janet Yellen pointed out on Tuesday (Mar 21) as she hinted at those plans, is a classic bank run, rather than an asset-related blow-up.

Millions of Americans – suddenly worried about the safety of their bank deposits – are trying to withdraw cash, making this worry a reality. Compared to previous crises involving abstruse derivatives, this one is devilishly simple. It may also be harder to contain.

The FDIC is an independent federal agency that insures deposits in US banks and thrifts in the event of bank failures. Last week, it made an arbitrary, off-the-cuff decision to rescue all depositors of Silicon Valley Bank (SVB) – the first bank to go under – in hopes of preventing the panic from spreading.

It did not work, and now Yellen is seeking power for the agency to make sure it can save others in the same position. Otherwise, it would have to pick and choose the institutions that will survive the crisis.

But as some analysts have pointed out, how does one rightfully decide if a person’s small community bank is important enough?

Among the efforts to expand deposit insurance is a proposed bill from California Democratic House Representative Ro Khanna to increase the amount insured by the FDIC from the current cap of US$250,000.

The Republican House Freedom Caucus quickly voiced its opposition, dubbing the proposal a bailout that would waste taxpayers’ money and stoke inflation.

Speaking to the American Bankers Association on Tuesday, Yellen appeared to go a step further than Khanna, promising to protect all depositors at small banks. It is unclear at this stage, however, if Yellen could do so without having the measure approved by the divided US Congress.

Strategists say her ambitious plan comes with at least three potential unintended consequences.

One is the danger of “moral hazard” as banks take reckless risks because of the safety net. Another problem is that smaller banks could lose their role in the system, as the expanded guarantee allows savers to keep all their eggs in one basket. And finally, there is the danger of renewed panic if and when the FDIC takes the safety net away.

“It comes back to moral hazard and competitiveness, making sure we have a diversified banking system with quite a few options,” said Brent Schutte, chief investment officer at money manager Northwestern Mutual Wealth Management.

“I think they are looking at it as an option as they plan for the ‘what ifs’, but there’s certainly some aversion towards doing it.”

Specifically promising to support small and mid-sized banks, Yellen attempted to stop the current flood of money from smaller banks to giants such as JPMorgan and Bank of America, viewed as both inherently safer and more likely to be fully backed by the government in an emergency.

Ironically, said Schutte, smaller banks could be hurt by an unlimited deposit insurance scheme, because savers would no longer have the incentive to distribute large sums between multiple banks. 

Shares of First Republic, one of the mid-sized banks currently experiencing a run on its deposits comparable to SVB’s situation before its Mar 11 failure, shot up by almost 30 per cent after Yellen’s speech on Tuesday.

But the bank returned some of those gains in late trading that day, amid reports that the government would orchestrate a takeover, likely for the kind of unfavourable terms that the Swiss government imposed on Credit Suisse.

One unintended consequence of backstopping every bank is the incentive created to take exorbitant risks. If a risky book of loans pays off, the bank stands to gain. Should the loans default, depositors will be bailed out anyway, thereby keeping the bank in business.

The “extreme” version of this is the zombie bank, said Quincy Krosby, chief global strategist at brokerage LPL Financial. This is an insolvent institution that is propped up by the government and blunders its way around the banking system, causing a deterioration of interbank trust.

The FDIC was founded in 1933, after the last major breakdown in trust of the fractional-reserve banking system. In this system, each bank lends out more money than it takes in as deposits.

Typically, depositors only draw large sums from their accounts on rare occasions, such as for the down payment on a house. That is why banks are considered well capitalised when they have only 10 per cent of deposits in liquid cash.

Only when trust breaks down entirely do large numbers of depositors clamour for their cash at the same time. The FDIC helped break the cycle of bank runs by guaranteeing that it would make depositors whole.

The FDIC gave all Americans a chance to insure deposits without an upper limit during the 2008 financial crisis – for a fee. The agency also doubled the cap to US$250,000.

Still, that was a different kind of crisis, a solvency problem as Wall Street banks such as Lehman Brothers were ruined by toxic investments. Most conventional, “money-centred” banks were viewed as places of refuge. Americans lined up to withdraw from uninsured savings institutions and dumped their stock holdings, but they generally kept their money in deposit accounts.

One way to look at the current crisis is that the FDIC’s cap – even though it was doubled in 2008 – did not keep up with inflation.

After a housing boom and years of wage growth, many Americans now deposit sums much larger than that in their local banks. This leaves uninsured deposits at their highest level since the last time small and mid-sized banks experienced panics – the Great Depression.

Billions, if not trillions, of dollars of uninsured deposits have been sitting in banks such as SVB, Signature Bank, First Republic and others for decades.

Guaranteeing all these deposits, as Yellen seems intent to do, would be a sure-fire way to stop the panic. Not even the US government can afford to cover those trillions forever, of course.

Every time in the last 15 years that the Federal Reserve attempted to withdraw the extraordinary support measures designed to break the 2008 crisis, markets panicked anew. Arguably, this year’s rate hikes were the final part of the unwinding of that support. 

Raising the caps alone, which seems likely to meet with Congressional resistance, may not be enough. But at least it would be an affordable measure of support, and one that does not bear with it the seed of the next panic.