If Banks Want More Deposit Insurance, They Should Pay for It

On Monday, news broke that the Treasury Department is studying how to officially raise the nation’s deposit guarantee above $250,000 in response to the ongoing banking crisis. The news comes on the heels of the decision by the Treasury, Federal Reserve, and Federal Deposit Insurance Corporation (FDIC) to guarantee all uninsured deposits at the failed Silicon Valley Bank and Signature Bank. Treasury Secretary Janet Yellen said in a speech Tuesday that the Treasury is prepared to take similar actions if other banks threaten to collapse.

The emergency unlimited deposit insurance is grounded in a simple idea: if depositors at failed banks face no loss on their deposits, individuals and businesses who bank at other fragile banks will feel more confident in the security of their own deposits, stopping a more widespread bank run in its tracks.

Significantly enhanced or unlimited deposit insurance would be a major gift to privately run banking institutions. If regulators are serious about moving forward and expanding deposit coverage, Congress must require banks to pay for the privilege. Any unlimited deposit insurance scheme needs to be paired with additional regulatory reform of the regulated and unregulated banking sectors alike and a significant increase in risk premia banks pay to the FDIC. Without Congressional action, we run the risk of creating a new standard for crisis response that could cause more bank failures, not fewer.

Enhanced deposit insurance could indeed help in stemming this current panic and preventing the next. The stakes are not small: in the FDIC-insured banking system, at the end of last year, uninsured deposits amounted to $7.7 trillion, over 40 percent of all deposits. A sweeping guarantee of those deposits could make traditional bank runs a relic of the past—why leave a bank in distress when you know you’ll still have access to all of your money if it fails? It would make clear that we should not expect depositors, whether they are individuals or small businesses, to closely follow the financial health of the bank they use. The guarantee could also make it simpler for larger businesses to manage cash flow needs by reducing their reliance on cash-like financial products, such as money market mutual funds or insured cash sweep accounts that spread money across many banks to stay within the FDIC’s current $250,000 limit.

Why has deposit insurance not been unlimited in the past? Banks serve public purposes – the intermediation of credit and the creation of money – but are motivated by private sector aims of financial gain. A deposit guarantee would meaningfully change this relationship by providing a new advantage to banks, a significantly more stable deposit base. Policymakers and economists alike have been concerned about the “moral hazard” that might produce: if banks don’t face the threat of a run, they will use that stability to invest in riskier or less liquid assets, chasing yield that will enhance their profits. Government’s deposit guarantee, a public good, would be used to enhance the profits of banks. If a bank fails, its equity and bond holders might be wiped out, but the smart investors would have enjoyed years of subsidized returns before the collapse.

Read More: Who Is Really to Blame for the Silicon Valley Bank Collapse?

One way to prevent this would be to limit the risks banks could take, specifically by tightening existing regulation including capital and liquidity requirements. Banks provide critical financial services because governments give them the exclusive power to transform short-term liabilities into longer-term assets. If a critical liability, the deposits, are going to be made run-proof, we should expect banks to keep more cash on hand in case a crisis occurs and depositors want their money back. The largest “too big to fail” banks already face enhanced requirements thanks to governance changes in the years after the 2008-2009 Great Financial Crisis. But in 2018 Republicans in Congress, joined by a handful of Democrats, rolled back these requirements on most banks, one of the primary reasons we face the crisis we have today.

In addition, Congress would need to pair unlimited deposit insurance with significantly higher fees to the FDIC for deposit insurance. These should be carefully linked to the leverage of a bank to ensure that the riskiest banks pay the most for the insurance their depositors enjoy.

Tighter regulation of this sort could have problematic side effects, specifically tempering banks’ ability to extend credit to borrowers. Businesses in search of credit have in many cases a ready alternative to the traditional banking sector: the network of hedge funds, private equity funds, and investment banks that make up the so-called “shadow banking” sector (i.e. major financial companies like Blackrock and Apollo). Nearly all major financial institutions touch the unregulated world of shadow banking in some form through their borrowing and lending activity. For instance, when a company in need of funds sells an asset with a promise to buy it back shortly later, the repurchase agreement created establishes a short-term credit relationship. Most of the time, these agreements can be renewed or “rolled over,” creating a depositor-like banking relationship. This is functionally banking, but importantly, without the need for a banking charter.

Estimates of the size of the sector vary because there are no comprehensive reporting requirements, but the Financial Stability Board, a global body that monitors the financial system, pegs the size of the non-bank financial intermediation in the U.S. at $20 trillion, about 15 percent of American financial assets.

Despite the name, shadow banking is not inherently nefarious; a good deal of the activity can improve the functioning of financial markets. Money market funds, for instance, enable millions of Americans to earn a return on cash-like deposits by gaining access to yield-bearing financial products that would otherwise be difficult to access. This is especially important in eras of high inflation. Similarly, repurchase agreements create helpful liquidity for large companies in need of short-term cash or those interested in using their excess cash to earn a modest return.

The problem is that shadow banks are not subject to the same regulatory requirements of traditional banks, but they enjoy an effective public guarantee. When crises occur, the Federal Reserve, working in consultation with the other institutions of government, steps in to provide systemic insurance, as they did in 2008, 2020, and again this month. The Fed now even uses its own repurchase agreement facilities as a primary method of implementing monetary policy. When a crisis occurs, we know that the U.S. government will support the institutions involved in bank-like activity, even if they have not been appropriately regulated before. The shadow banks thus enjoy the opportunity to engage in bank-like financial activity without the regulatory requirements that traditional banks have.

Unlimited deposit insurance and greater capital and liquidity ratios, as desirable as they may be, could inadvertently push more funding into this largely unregulated money market, creating more instability, not less. Investors often find ways around rules to achieve results similar to what the government tried to control. If new legislation requires regulated banks to pay for the privilege of unlimited deposit insurance, then shadow banks will need to enter the regulatory perimeter to ensure that they do not become the sites of increasingly risky behavior.

Policymakers today need to simultaneously restore depositor confidence and address the risks an unlimited deposit guarantee might introduce. If Congress takes no action, it is likely that unlimited deposit insurance guarantees will be introduced again in the next crisis, creating a dangerous precedent and ignoring the risks to financial stability.