If you buy a home with a mortgage, you need insurance on the house. Not on part of the house, but on the whole thing.
Yet you can put money in a bank and only have insurance on some of it—and if you’re wealthy, only a tiny portion of it. The Federal Deposit Insurance Corp. (FDIC) insures deposits up to $250,000, through premiums banks pay for the coverage. For most ordinary people, that’s plenty of insurance, since the average bank balance is around $42,000. But when Silicon Valley Bank, or SVB, failed in early March, 94% of its deposits were above the insured amount, a glaring vulnerability that helped trigger a startling run on the bank and destabilized the regional banking sector.
Regulators and banking experts are now pondering whether it’s time to dramatically change the deposit-insurance system so that most or even all deposits in ordinary banks are covered by insurance. Federal regulators have already invoked emergency measures to cover all uninsured deposits at SVB and, implicitly, at any other bank that might fail. Some members of Congress are drafting legislation to formally change a deposit insurance system that still resembles the Depression-era stopgap that first went into effect in 1934.
“Coverage caps on federal deposit insurance have become not only anachronistic, but dangerous,” Robert Hockett of Cornell Law School writes in a new paper outlining how universal deposit insurance could work. “We have a much better solution in plain sight … remove all caps on federal deposit insurance, continue to risk-price its premia as required by law and afford FDIC the option of progressively pricing those premia as deposit amounts grow.”
Throughout the banking system, about 43% of all deposits are uninsured. If a bank fails, the government will cover 100% of deposits up to $250,000. In theory, deposits above that amount are supposed to be treated like assets managed in a takeover or liquidation, and sometimes redeemed at less than 100%. But that’s not what happened when SBV failed. The government covered all deposits, including the uninsured ones, because doing otherwise could have led to runs on uninsured deposits at hundreds of other banks and caused an immediate financial crisis.
The government is now implicitly guaranteeing all bank deposits, even though banks only pay for coverage up to the $250,000 limit. So why not change the rules, establish universal deposit insurance, or UDI, and charge banks enough in premiums to cover all deposits?
This might sound like nanny-state tinkering that distorts the necessary checks and balances of capitalism. But the failure and bailout of SBV distorted capitalism on its face. Bankers who should have been constrained by the risk of failure took bad risks and failed anyway. Wealthy depositors who stood to lose millions demanded that the government cover their losses, and they got their way. Regulators might have done what is necessary, but we now have a deposit-insurance model that is effectively subsidizing banks by providing insurance above $250,000 that banks aren’t paying for.
Universal deposit insurance, which Congress would have to establish through legislation, might be a businesslike solution that works the way most people think of insurance: by charging a fair price for comprehensive coverage that provides robust guarantees for everybody, with no freeloaders.
Bank critics worry that banks will pass new deposit-insurance costs onto the lowest-tier consumers. But UDI could be structured to prevent that. A starting point would be leaving the system intact for individual depositors with $250,000 or less in an account: Same insurance coverage, no new fees.
Above that amount, the most important goal would be protecting “transaction accounts” businesses maintain to cover payroll and other routine bills. That turned out to be the biggest problem at SVB. Wealthy individuals with uninsured deposits at the failed bank could have survived as creditors getting back a portion of their money. Most millionaires and billionaires don’t keep cash in an ordinary bank, anyway—they employ money managers to disperse their funds and make sure it’s safe. Businesses, however, need a lot of cash on hand, and could end up the primary beneficiaries of universal deposit insurance.
The government could price insurance for business accounts above $250,000 based on the size of the account, the riskiness of the bank and other factors the government already measures as it regulates banks. There might be more variability among banks, because they might not all choose the same type of coverage, as they do now with the one-size-fits-all FDIC option. But a menu of choices might not pose a problem for businesses.
“As long as the simple option was available for anybody who wanted it, you could assess fees on larger depositors and maybe make them conform to a graduated schedule,” Hockett told Yahoo Finance in an interview. “It would be very easy for a business thinking about where to bank to ask, ‘What are the account options?’” Banks could pay premiums on a tiered basis: One set of premiums for accounts between $250,000 and $1 million, for instance, another set of premiums for $1 million to $10 million, and so on.
None of this would apply to investment banks, brokerages, or other types of financial firms that don’t hold normal customer deposits and don’t qualify for deposit insurance now. Higher coverage levels could exempt the accounts of wealthy individuals, who would still have to manage risks. The point would be to assure businesses their money is safe, so they can focus on whatever they do instead of their bank’s soundness. Poorly run banks could still go bust, with shareholders losing out first, bondholders next, and bank managers facing penalties or prosecution if they’re incompetent or criminal.
One banking group has already asked the government to insure all deposits at midsized banks for two years, to eliminate any doubt among depositors about whether their money is safe. Banks would pay for the additional coverage. Treasury Secretary Janet Yellen says the government will do whatever is necessary to safeguard the banking system, but the Biden administration hasn’t committed to any formal measures beyond the bank rescues it has already executed.
Some bankers hate the idea of expanded deposit insurance that would add fees and bring more oversight to a sector already heavily regulated. Many small and regional banks are in fine shape, and some of those bankers say they shouldn’t bear the cost of bad decision-making at SVB and a few others that mismanaged interest-rate risk.
There’s also the obvious problem of moral hazard—excess risk-taking that might occur if banks think all mistakes are insured. And there are always risks of unintended consequences, such as the possible outflow of cash from money-market funds at investment firms such as Vanguard, Fidelity and Schwab if there’s suddenly no risk to investors of keeping millions at a bank.
The Independent Community Bankers of America, which represents about 5,000 smaller banks, doesn’t rule out changes to deposit insurance. But the group argues that any changes must apply equally to big banks and small ones, so as not to add to advantages giant lenders such as JP Morgan Chase and Citibank already have. “ICBA has not endorsed a universal deposit guarantee and agree that it is not currently necessary, though we would consider the need for expanding deposit insurance should there be significant changes negatively affecting the nation’s financial stability,” Anne Balcer, the group’s chief of government relations, told Yahoo Finance in a statement. “If any adjustments are made, even on a limited basis, they cannot discriminate and leave others out, particularly the nation’s community banks.”
Some members of Congress are proposing an increase in deposit insurance, which Congress has done before. FDIC insurance covered just $2,500 in 1934. Congress most recently raised the limit from $100,000 to $250,000 in 2008, during the financial crash. So it could do so again. The question seems to be whether it should be an incremental change that basically adjusts for inflation and leaves the system more or less as it is, or more fundamental change that could alter the way we bank. And it may be the way we bank that needs changing.