Deposit insurance can be harmful. Courtesy | Bloomberg
The Federal Reserve’s mixed messages following the recent failures of Silicon Valley Bank and Signature Bank have left the United States financial sector on edge. After admitting that raising deposit insurance might be a good idea, Treasury Secretary Janet Yellen quickly backtracked to assure Americans that the Treasury Department is not considering blanket deposit insurance. Despite these promises, Americans should view any attempt to raise deposit insurance as a horrible idea.
The Federal Deposit Insurance Corporation insures the majority of deposits across the banking system up to $250,000. If a bank fails, the FDIC guarantees those deposits, but anything over that amount is lost. At least, that’s how it’s supposed to work.
Over the years, critics of the FDIC have argued that deposit insurance can create more bank failures than it prevents. Researchers at the American Institute for Economic Research noted that while deposit insurance theoretically safeguards against bank runs, it also creates a moral hazard problem in banks, which is far more dangerous.
“Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost,” according to Economic Times. It’s a common problem for insurance companies because an insured party will behave in a riskier manner if they know they are protected against the cost.
In the same way, researchers have noticed that increased deposit insurance leads to increased bank fragility. Banks are more likely to make risky investments with depositors’ money, and depositors are less likely to weigh banks based on safety if they know they’ll get their money back regardless of the outcome.
The same researchers also argued that models promoting the benefits of deposit insurance are purely theoretical, and point to studies showing how countries with increased deposit insurance have a higher risk for banking crises. They also link high deposit insurance to both the savings and loan crisis of the 1980s and the 2008 financial crisis.
Silicon Valley Bank failed for various reasons, but commentators note two significant ones: investments losing value and depositors hastily withdrawing funds. In theory, FDIC insurance would have decreased the likelihood of a bank run––except 85% of accounts at SVB were uninsured because they exceeded $250,000.
Would more deposit insurance have made a difference? In the long run, no. The FDIC promised to insure all accounts at SVB, regardless of how much money depositors had. More deposit insurance could have also encouraged SVB to make even riskier investments, which was already a problem for the bank.
Different factors caused Signature Bank’s failure, the main one being the fear of contagion in the banking sector. Regulators closed the bank to prevent further panic and bank runs. However, the FDIC promised to ensure those deposits as well, even if they exceeded the limit.
These bank failures, combined with previous research on deposit insurance in general, have raised troubling questions in the financial sector. Even though Yellen won’t officially commit to blanket deposit insurance, the FDIC’s recent actions leave the door open for future guarantees while also creating more chaos.
If depositors assume that the FDIC will insure all deposits from now on––whether they admit it or not––they will deposit money more haphazardly. Banks will be more likely to act in a risky manner.
If the FDIC is not providing de facto deposit insurance, how will it determine which banks to cover and which ones to let fail? Silicon Valley Bank was the 16th largest bank in the U.S. and Signature Bank was the 19th largest. Neither was considered “too big to fail,” a term that refers to businesses (often banks) that are so ingrained in the economy that their failure would be disastrous.
Will the FDIC now provide blanket insurance for all regional banks or only some? How will it determine which banks to cover? The answers could determine the future risk of America’s financial sector.
No matter what the Treasury Department decides, the U.S. banking system is continuing toward fragility. If Yellen and the FDIC truly want to stabilize the economy, they should not provide banks any more deposit insurance than they already have.
