US banking failures highlight deposit insurance effectiveness

Even though it didn't affect as many countries as the Global Financial Crisis (GFC) of 2007-2009, or at least didn't act as many people, the U.S. banking crisis 2023 hugely affected the global banking system. With the end of First Republic Bank in early May and the failures of Silicon Valley Bank (SVB) and Signature Bank in March, the United States saw the second, third, and fourth largest bank failures in the country's known history. When inflation is considered, the total assets of just those three lenders are more than that of all 25 banks that failed in 2008, which is $532 billion compared to $526 billion; this shows how important this year's events are. After it was found that many of the deposits at the banks that failed this year were not insured, the 2023 problem has raised serious questions about the point of deposit insurance.

The Federal Deposit Insurance Corporation (FDIC), a government body, runs U.S. deposit insurance. It ensures that up to $250,000 per account in insured banks is safe. In 1933, during the Great Depression, when 40 per cent of U.S. banks had already failed, the U.S. Congress passed the Banking Act, which created the FDIC to get people to trust banks again. The highest insurance limit used to be $2,500, but it has been raised several times since then. The most recent time was in 2010 when the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was passed; this meant that the FDIC would insure bank deposits up to $250,000.

This amount is more than enough for most homes. But for most businesses, more is needed to cover their holdings, which can be worth millions of dollars, so a big chunk of U.S. bank accounts still needs to be covered. S&P Global Market Intelligence predicted that by the end of 2022, this large share would be almost 45 per cent, or $7.7 trillion, a big jump from 2009 when it was only $2.3 trillion. The FDIC found more than 94% of SVB's deposits were uninsured. Many of the bank's tech start-up users chose to keep all of their money there.

Many people were surprised when Secretary of the Treasury Janet Yellen decided to use a systemic-risk exception to guarantee all accounts at SVB and Signature Bank, even those over the $250,000 limit, to stop more people from running on banks. The Deposit Insurance Fund (DIF) of the FDIC went from $128 billion in assets at the end of 2022 to $116 billion by the end of the first quarter of 2023; this was before another $13 billion was spent to deal with the failure of First Republic Bank in early May, which JPMorgan Chase then bought.

Was it the best choice for the government to support all depositors? After all, it meant that the $250,000 cap, intended to protect wealthy customers with uninsured deposits, could have been more helpful. And some people say that risky banks like SVB didn't just end up with many uninsured savings by accident. Instead, they say these deposits were needed to support the banks' increasingly risky ventures over many years. In a recent article for the Financial Times, Todd Baker, a senior fellow at Columbia University's Richard Paul Richman Centre for Business, Law, and Public Policy, talked about this trend. He said that shareholders getting more involved and bank managers getting paid with stock awards were strong incentives for taking such risks. He also said deregulation and the "steady financialisation of the U.S. economy" were good for high-risk investments and capital-market activities.

"Many new financial players and ways to create financial leverage, risk, and return came into life, such as securitisation, private equity, derivative trading, venture capital, shadow banks, high-speed trading, money market funds, and private debt providers, to name a few. "Bank managers who wanted to take on more risk had a lot of new options," Baker wrote. "What used to be a big deal with the government, in which banks agreed to run their businesses conservatively, hold extra capital and liquid resources, only do practical and low-risk things, and be subject to strict supervision in exchange for the stability that federal deposit insurance brought to their business models, turned into unbalanced and uncontrolled private risk-taking that was paid for by the government. Recent banking shenanigans show that changes made after the crisis have helped, but more is needed to solve these problems.

These perks are a big reason why SVB and First Republic Bank took on more accounts that were not insured. "The Fundamental Role of Uninsured Depositors in the Regional Banking Crisis," a study published on July 12 by Briana Chang of the University of Wisconsin, Ing-Haw Cheng of the University of Toronto, and Harrison Hong of Columbia University and the National Bureau of Economic Research (NBER), found five key facts that support the idea that "greater bank risk-taking and uninsured deposits go together in equilibrium":

From January 2022 to March 2023, banks with more uninsured accounts had lower returns and more stock-price risk than other banks.

Even before 2022, regional banks with more savings that weren't insured tended to be riskier.

Banks with more uninsured savings also made more money, had better valuation ratios, and saw their deposits grow more.

Based on capital levels and other balance sheet measures, these banks weren't much riskier.

The pay and benefits for the top people at these banks were the same or even higher, which was tied to them taking more risks.

The writers say that these kinds of facts show that banks like SVB need a lot of uninsured deposits to back up their risky strategies. "While the emerging story after the crisis emphasises the importance of uninsured deposits in bank runs (Fact 1), this view doesn't explain why uninsured depositors (who are probably worried about bank defaults) would stick with risky banks as they did before the crisis (Fact 2)," the paper argued. "In fact, during this time before the crisis, banks with more uninsured deposits were more profitable and valuable and saw more money come in (Fact 3), even though they were taking on more risk. This suggests that their business strategies are good." Fact 4 shows that uninsured accounts show a different type of risk than what's shown on the balance sheet. Fact 5 adds to the idea that taking risks is part of a business strategy since such plans require high executive pay and strong incentives to be carried out in a balanced way.

But this year's bank failures have helped cut the number of uninsured accounts at U.S. banks by a considerable amount. On June 12, S&P Global Market Intelligence said, "As of March 31, the industry reported $7.118 trillion in uninsured deposits, which made up 42.2% of total deposits minus exclusions." This was a 7.8% drop from the final quarter of last year and a 15.2% drop from the same time the previous year. "This was down from $7.716 trillion, or 44.9% of total deposits, on December 31, 2022, and $8.398 trillion, or 47% of total deposits, in the same time last year." S&P found that the number of uninsured accounts at 20 of the 25 U.S. banks with at least $25 billion in assets on March 31 went down from the previous quarter.

Regulators are also thinking about changing how deposits are insured to make it less likely that there will be more bank runs. One idea is to get rid of the $250,000 limit and cover all bank savings in total. But such a system would be expensive and might not give banks a reason to act more carefully. "As a policy reaction to SVB's failure, this bank's depositors are fully insured. "This decision has sparked a larger debate about whether deposit insurance coverage should be raised above its current limit of $250,000 in the U.S.," Guillaume Vuillemey, an associate professor of finance at HEC Paris School of Management, wrote in an article for the Centre for Economic Policy Research (CEPR). "My analysis doesn't say anything about this, but it does suggest that such a measure could be a big subsidy for the "rich" in general, including the wealthiest households and companies with a lot of cash. These agents would get more safety than other economic agents."

Another possible solution is to replace the single $250,000 threshold with a two-tiered system with the same coverage for individual accounts and higher coverage for day-to-day business accounts. The FDIC says this would be cheaper and less likely to encourage banks to act in risky ways. The chair of the FDIC, Martin Gruenberg, noted that this kind of targeted coverage would have "the greatest chance of meeting the basic goals of deposit insurance concerning its costs."