Editor’s note: In his column for July’s BankBeat magazine, Publisher Tom Bengtson said the FDIC’s deposit insurance limit should remain where it is. In an April roundtable hosted by The Brookings Institution, Prasad Krishnamurthy, Professor of Law at the University of California, Berkeley, argued the opposite position, lightly edited here.
We should significantly consider extending the cap far beyond what it currently is now.
First, we have to acknowledge that so-called uninsured deposits are actually insured. All of the deposits in Silicon Valley Bank and Signature Bank were insured after the fact. Neither of these banks was on the Federal Reserve’s radar as a systemically risky or important institution.
The decision to insure all the deposits was done through joint action by the Federal Reserve and the FDIC and Secretary of Treasury. Consider Secretary Yellen’s remarks in the aftermath of that decision. On March 16, she stated to the Senate that uninsured depositors would be protected, for failure to do so “would create systemic risk and significant economic and financial consequences.” So this covers all depositors and all the major or systemically important financial institutions. That’s a lot of deposits.
On March 23rd, she told the American Bankers Association similar actions could be warranted as smaller institutions suffer deposit runs that pose a risk of contagion. So blanket deposit insurance also extends, in many instances to smaller institutions as well.
Whether we like it or not, deposit insurance for the so-called uninsured does exist, in fact, and it exists because policymakers have this commitment problem. Secretary Yellen or Chairman Powell or really anyone in their situation is always going to err on the side of insuring deposits when there is stress on the banking system because they’re afraid that depositors will just exit the banking system en masse and go and buy government bonds for safety.
Given this fact and undeniable implicit insurance, it makes sense to potentially consider a more orderly and rational system of deposit insurance. To use one example: We could expand the existing system and cover all deposits that are in the banking system. The FDIC could assess a fee to all banks on the basis of their total deposits and any other factors that go into bank insolvency. And we can do this in such a way that smaller depositors would not be hurt and the brunt of the costs would fall on large depositors.
With explicit insurance, bank depositors would not be able to threaten the stability of the banking system in a crisis. Instead, actually, the crisis funds would flow into the banking system because of the insurance, and the Fed would be able to conduct monetary policy without worrying about interest rate moves that would trigger a banking panic.
Now, the most important criticism of this expanding deposit insurance trade is that the banking system would actually become less safe because depositors would now ignore risk and banks would take advantage of the cheap funding that they would get and banks would become riskier. This phenomenon is known as moral hazard, and it’s the phenomenon of ignoring risk whenever you’re insured against it.
This is a real concern, but I think there are a number of steps that could be taken that could mitigate this. First, banks would need enough capital and they would need enough subordinated debt to make sure that those instruments would have absorbed the first losses in the wake of a crisis. Thus the depositors would be substantially subordinated in the bank’s financial structure. Second, regulators would need to assign insurance premiums that were based both on regulatory measures of risk and on market-based measures of risk, because both of them capture independent things. Regulators would need to act promptly in order to fail resolving banks and to resolve banks so that the deposit insurance fund could be protected from loss. And then finally, it’s worth considering a cap on deposit interest rates. A cap on rates would prevent depositors from running out to the bank that would give them the highest yield. The Federal Reserve, just as it sets an overnight rate for bank funds, could set short term rates for deposits, and this would also give the Fed an additional tool of monetary policy.
All of the reforms that I’ve suggested should be considered, even if we don’t expand deposit insurance explicitly, because as an implicit matter that deposit insurance already exists and there’s already moral hazard in our system because of it.