By Alexander Jones, International Banker
Although not on the same geographical scale as the 2007-09 Global Financial Crisis (GFC)—or, at least, not involving the same numbers—the US banking crisis of 2023 has nonetheless had a profound impact on the global banking system. With the demise of First Republic Bank finalised in early May following the failures of Silicon Valley Bank (SVB) and Signature Bank in March, the United States witnessed the second, third and fourth largest bank failures in the country’s recorded history. And with the total assets of just those three lenders eclipsing the combined assets of all 25 banks that failed in 2008—$532 billion versus $526 billion when adjusted for inflation—the significance of this year’s events cannot be overstated. After large proportions of the deposits held at this year’s banking casualties were revealed to be uninsured, the 2023 crisis has seriously called into question the purpose of deposit insurance.
Operated through the Federal Deposit Insurance Corporation (FDIC), a government agency, US deposit insurance guarantees the safety of depositor funds at insured financial institutions up to $250,000 per account. It was first launched in 1933 amid the Great Depression (after 40 percent of all US banks had already failed) when the U.S. Congress passed the Banking Act, establishing the FDIC as a vehicle to restore public trust in the banking system. First capped at $2,500, the maximum insurance threshold has since been raised on several occasions—most recently in 2010 with the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which resulted in the FDIC insuring bank deposits up to $250,000.
For most households, this limit is more than enough. But for most businesses, it is inadequate to cover holdings that often stretch into the millions, so a hefty portion of US bank deposits remains uninsured. Indeed, S&P Global Market Intelligence calculated that hefty portion at almost 45 percent as of the end of 2022, or $7.7 trillion, having increased substantially from the $2.3 trillion recorded in 2009. As for SVB, more than 94 percent of its deposits were found to be uninsured, according to the FDIC, with many of the bank’s tech start-up customers choosing to hold all of their funds with the bank.
Secretary of the Treasury Janet Yellen’s decision to invoke a systemic-risk exception to guarantee all SVB and Signature Bank deposits, even those above the $250,000 limit, to prevent wider runs on the banking sector startled many. This decision brought the FDIC’s Deposit Insurance Fund (DIF) down from $128 billion in assets at the end of 2022 to $116 billion by the end of 2023’s first quarter, before a further $13 billion was spent dealing with the early-May failure of First Republic Bank, which JPMorgan Chase subsequently purchased.
Was the decision by the regulators to backstop all depositors the wisest one? After all, it meant that the $250,000 limit was rendered effectively meaningless to protect wealthy customers holding uninsured deposits. And according to some, the accumulation of uninsured deposits by risky banks such as SVB was no accident; rather, they were necessary to support the increasingly risky ventures embarked upon by such banks over many years. Todd Baker, a senior fellow at the Richard Paul Richman Center for Business, Law, and Public Policy at Columbia University, recently discussed this trend in a piece he wrote for the Financial Times. He pointed to progressively more active shareholders and bank managers being compensated through equity awards as strong incentives for such risk-taking amidst an inviting environment of deregulation and the “steady financialisation of the US economy”, further conducive to high-risk investment and capital-market activities.
“Many new financial players and myriad new ways to create financial leverage, risk and return came into existence, like securitisation, private equity, derivative trading, venture capital, shadow banks, high-speed trading, money market funds and private debt providers, to name only a few. Bank managers seeking to add risk had many new tools to choose from,” Baker wrote. “What had been a grand bargain with government—in which banks agreed to run their businesses conservatively, hold excess capital and liquid resources, only do certain useful and relatively low-risk things and be subject to strict supervision in exchange for the business model stability that federal deposit insurance brought—turned into unbalanced and unbridled private risk-taking, subsidised by a public backstop. The recent banking shenanigans show that post-crisis reforms have helped, but not sufficiently tamed these issues.”
Those incentives appear to have played a crucial role in SVB and First Republic Bank taking on more uninsured deposits. “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]) established five key facts in support of the view that “greater bank risk-taking and uninsured deposits go together in equilibrium”:
- Banks with more uninsured deposits experienced worse returns and greater stock-price risk than other banks in the January 2022-March 2023 period.
- Even before 2022, banks with greater uninsured deposits tended to be riskier in the cross-section of regional banks.
- Banks with more uninsured deposits were also more profitable, had better valuation ratios and experienced greater deposit growth.
- According to capital ratios and other balance-sheet measures, these banks did not seem significantly riskier.
- These banks had similar or larger executive pay and incentives, which were themselves related to greater risk-taking.
According to the authors, such facts build the case that banks like SVB require large amounts of uninsured deposits to support their risky strategies. “While the emerging narrative after the crisis emphasizes the importance of uninsured deposits in bank runs (Fact 1), this perspective leaves open why uninsured depositors (who are presumably worried about bank defaults) would attach themselves to risky banks as they do even before the crisis (Fact 2),” the paper argued. “Indeed, during this pre-crisis period, banks with greater uninsured deposits were more profitable, valuable, and experienced inflows (Fact 3) despite their greater risk, suggesting that they have valuable underlying business strategies. Fact 4 indicates that uninsured deposits capture a dimension of risk beyond those captured by what is on the balance sheet. Fact 5 further supports the idea that risk-taking was part of a business strategy since such strategies at financial firms require high executive pay and strong incentives to execute in equilibrium.”
But it appears that this year’s bank failures have helped to reduce the total level of uninsured deposits at US banks drastically. “The industry reported $7.118 trillion in uninsured deposits at March 31, making up 42.2% of total deposits minus exclusions,” S&P Global Market Intelligence reported on June 12, noting a 7.8-percent sequential decline for last year’s final quarter and a 15.2-percent drop year-over-year. “This was down from $7.716 trillion, or 44.9% of total deposits, at December 31, 2022, and $8.398 trillion, or 47% of total deposits, in the year-ago period.” Twenty of the 25 US banks that had at least $25 billion in assets on March 31 also reported a quarter-over-quarter decline in uninsured deposits, S&P observed.
Regulators are also mulling changes to the current deposit-insurance regime to minimise the likelihood of further bank runs. One proposal is to remove the $250,000 cap altogether and fully insure all bank deposits. However, such a solution would be costly and might not incentivise banks to operate more prudently. “One of the policy responses to the failure of SVB has been to fully insure depositors at this bank. This decision has raised a broader debate about whether deposit insurance coverage should be increased above its current threshold ($250,000 in the US),” Guillaume Vuillemey, an associate professor of finance at HEC Paris School of Management, wrote in a piece for the Centre for Economic Policy Research (CEPR). “While my analysis is silent on this issue, it suggests that such a measure could act as a major subsidy to the ‘rich’ in general: the wealthiest households in the economy and the cash-rich corporations. These agents would be offered extra safety at the expense of other agents in the economy.”
Another potential solution on the table is the replacement of the single $250,000 threshold with a two-tiered system that would involve unchanged coverage for individual accounts but higher coverage for day-to-day business accounts, which, according to the FDIC, would be more cost-effective and less likely to promote risky bank behaviours. Such targeted coverage would have “the greatest potential for meeting the fundamental objectives of deposit insurance relative to its costs”, the FDIC’s chair, Martin Gruenberg, stated.