Wow, that was a mouthful. Even for me. Now that we're clear on just what happened with SVB and Signature Bank, let's talk about the topics in the title of this post.
First, deposit insurance. Nearly all banks, savings banks, and credit unions have federal deposit insurance, either through the Federal Deposit Insurance Corporation (FDIC), which insures bank and savings bank deposits, or the National Credit Union Association (NCUA), which insures credit union deposits. (Back before the S&L crisis, there was a third insurer, the Federal Savings and Loan Insurance Corporation, or FSLIC, but it's defunct now, and savings banks - the survivors of the S&L industry - are insured by FDIC.) FDIC and NCUA are government agencies. They're also regulators.
I said "nearly all" financial institutions have federal deposit insurance, because a relative handful of institutions have private insurance, but that's becoming increasingly rare. American Share Insurance (ASI), one such private insurer, insures the deposits of about 100 of the nation's 4,000-plus credit unions. ASI is not a regulator, but it is regulated and audited, and is supervised by credit union regulators in the states in which it operates.
(Although I've spent my career serving credit unions, I'm going to use the term "bank" throughout this blog post, because it's less cumbersome than typing "banks and credit unions," and because "bank" has four letters and "credit union" has 12, including the space. Sorry, credit unions, but I'm lazy. I still love you more, and I encourage readers of this blog to do business with a credit union.)
Bank deposits are insured up to $250,000 per account. A married couple can get creative, and hold up to $1 million in deposits with a single bank, fully insured, through structuring the ownership of the accounts between the two of them. Ask your bank for details. Naturally, you could have even more in insured deposits by spreading your money among different banks.
Now, let's talk about the history and purpose of federal deposit insurance, then we'll look at who pays for it. There's probably nobody reading this who lived through the Great Depression. My parents did, and I've heard their stories. And I've studied the economics of that period extensively. The crash of 1929 devastated the financial system. It made 2008 look like a stroll in the park. The suicide rate among bankers and Wall Street executives was high. Millions of people lost millions of dollars, and those were 1929 dollars; a dollar in 1929 would be $18.15 today.
Among the many reforms in response to the collapse of the banking system that took place in 1929 was the creation of the FDIC and federal deposit insurance, which was implemented on January 1, 1934. The initial deposit limit was $2,500.
This is a critically important point, and one that I'm going to be coming back to, so if you weren't paying full attention to the last paragraph, go back and re-read it now.
Deposit insurance is funded by the banks whose deposits are insured, not by the taxpayers. Sort of. Banks pay into the insurance fund, and when a bank fails, the fund covers the insured deposits. It does NOT cover the stockholders or the bondholders. When you buy stock or bonds, you assume the risk of your investment, and nothing insures that you'll get your money back. Everyone is supposed to understand that when they invest in stocks and bonds. The insurance fund is also not supposed to cover the uninsured deposits, for similar reasons. We'll talk more about that.
Why was deposit insurance put in place in the first place, and why was the limit set at $2,500?
Unemployment in 1929 was 3.2%, not too different from where it is today (3.6%). By 1933, it was nearly 25%. Think of it: a quarter of the U.S. labor force was out of work (and not just for a couple of months, as was the case when the COVID shutdown pushed the jobless rate to nearly 15%, but for the entire year). The average household income was $2,300 per year in 1929; by 1932 it had fallen to $1,500. Virtually everyone's savings was wiped out, because there was no deposit insurance, and ...
4,000 banks failed in 1933 alone. A total of 9,000 failed during the decade.
Compare that to the 25 that failed in 2008, and you see why there's no comparing the two crises.
Now, in 1929 the average family probably had less than $1,000 on deposit in a bank (I say "probably" because the data is scarce, but there's enough for me to make an educated estimate; if my Dad were alive, I'd ask him). The wealthiest income decile (what we'd call "the 10%" today), probably had at least ten times that amount, maybe $10,000 or more.
When FDR put together the New Deal, creation of the FDIC and deposit insurance was a part of it. And FDR - a Democrat, and a pretty liberal one at that - was primarily interested in protecting the small depositor, the average American family. He knew, being a very wealthy man himself, from a very wealthy industrial family, that the rich can take care of themselves; they can effectively self-insure. They take their own risks, and are expected to live with the consequences of those risks - and are entitled to reap the rewards.
So it isn't surprising that FDR's administration set the initial deposit insurance limit at $2,500 per account. That probably would have covered more than 100% of the deposit balance held by 90% of the families in the U.S. in 1929, before the crash, and it probably would have covered at least a fourth of the balances of the wealthiest 10% of American families in 1929. (The rest of them would have been assumed to be financially savvy enough to either divide their money into at least four different banks such that their full savings total would be insured, or they'd invest some of the money in riskier assets - at least at some point, after the Great Depression ended. In any event, they'd be expected to be able to weather the consequences of their own risk-taking, given their relative wealth.)
Today, the deposit insurance limit, as noted above, is $250,000 per account. Makes sense, you say; inflation, right? Well, I agree in concept. As inflation has increased, the amount of protection that the average family of average means should be afforded by deposit insurance should increase - by the inflation rate. So let's examine what that would look like.
There are various inflation calculators on the internet. The Federal Reserve Bank of Minneapolis has one; it goes back to 1913, although it only goes as far as 2022. However, we can extrapolate from 2022 to 2023 using the most recent year-over-year inflation data. So if we plug in the $2,500 federal deposit insurance limit that was in place in January 1934 - again, designed to protect average American families' bank deposits - and look at what that amount should be today, given inflation over the ensuing 89 years, today's deposit insurance limit should be ...
$58,195.46-. That's a lot less than $250,000, isn't it?
So who is federal deposit insurance protecting today? Well, let me ask you this: do you have $250,000 deposited in your bank? I sure don't. Do you know anyone who does? If you do, they're pretty well off, right? They're probably in a position where they can take their own risks, and bear the consequences if they take on too much risk - and they also probably reap the rewards for the risks they assume.
I actually know quite a number of investors who regularly deposit $250,000 in banks. They're credit unions. That's right, institutional investors, not individuals. Instead of buying bonds for their investment portfolios, they sometimes buy bank CDs. They'll put a few million dollars in bank CDs, with not more than $250,000 in any one institution so as to ensure that their entire CD portfolio is fully insured.
Now, they're in the business of managing risk. They normally buy bonds, which are subject to market value declines - and, in the extreme case, to default. So why should institutional investors be entitled to deposit insurance? That's not who it was intended for when it was conceived back in 1934.
That excess insured amount - in this case, about $191,805 per account - comes at a cost. To find out who pays the tab, read on.
As mentioned above, banks pay deposit insurance premiums to ensure there's enough in the insurance fund to cover the occasional bank failure. In so doing, they self-insure the industry. (It's not unlike you and me paying homeowner's insurance premiums; I may never need the coverage, but if my neighbor's house burns down, my premiums help provide the coverage needed to pay the claim. If my house burns down, my neighbors' premiums cover my claim. Either of us may pay premiums for the entire time we own our homes, and never have a claim. Likewise, a bank may pay deposit insurance premiums forever, and never fail.)
However, banks are a business. And like any business, they pass along the cost of doing business to their customers. Require restaurants to provide their workers with health insurance? Fine, but they're going to charge you more for a meal. Raise the minimum wage? Okay, but your groceries and other costs are going to go up, because businesses are going to pass along the higher wage and benefits costs to you, the consumer.
Charge banks an insurance premium to offer deposit insurance to protect depositors? All well and good. But they're either going to raise fees, or pay less interest on deposits, to cover the cost of those premiums.
And here's the most important point: increase the deposit insurance limit to offer greater protection for depositors? Okay, but you're going to need a larger balance in the insurance fund, to cover those depositors in the event of a bank failure. To build up that larger balance, you're going to need to increase the premiums you charge banks for deposit insurance. And if you increase banks' deposit insurance premiums, they're going to either increase fees, or take a larger haircut off the rates they pay on deposits.
It's like that children's book, "If You Give a Mouse a Cookie." A higher deposit insurance limit => larger insurance fund balance => higher deposit insurance premiums charged to banks => higher fees or lower interest rates for bank customers.
Fine, you say. If that's the price we as depositors must pay in order to be protected, so be it. Except ...
The proportionate burden of paying for deposit insurance, as borne by bank customers, is regressive. Let me explain.
Banks charge a number of fees. They charge maintenance fees just to have an account open. They charge fees if you overdraw your account. They charge fees for certain transactions.
Now, you can get those fees waived. How do you get them waived?
You carry a larger minimum balance. That's right - the largest depositors (those who receive the greatest benefit of high deposit insurance limits) benefit the most from those fee waivers, and thus the additional cost of that deposit insurance isn't passed along to them. It's borne by those who only need a much smaller amount of deposit insurance - say, about $58,000 or so; what the limit would be had it just been adjusted for inflation since deposit insurance was put in place in 1934.
In other words, the people who only need a relatively small amount of deposit insurance are paying the excess premiums for those who are enjoying the benefits of excess deposit insurance up to an amount that the smaller depositors will probably never accumulate.
Banks also pay interest. But they don't pay the same interest rates to all depositors. Some depositors get higher rates. Who gets the higher rates?
Depositors with larger balances.
Are you beginning to see the picture? Whether the banks pay for the excess insurance premiums through higher fees or lower interest rates, smaller depositors carry a disproportionate share of the burden, while large depositors enjoy all of the benefit by receiving all of the excess protection.
At the risk of channeling Jen Psaki, whom I'm sure we'd all just as soon forget, I'll "circle back" to deposit insurance and the limit toward the end of this post. But first, let's address how deposit insurance limits got so far ahead of where they should be given inflation.
The deposit insurance limit was doubled to $5,000 in June of 1934, just six months after deposit insurance was put in place. In 1950, it was doubled again, to $10,000, as part of the Federal Deposit Insurance Act. It was increased further to $15,000 in 1966, to $20,000 in 1969, and to $40,000 in 1974, as the U.S. economy faced multiple recessions in the 1960s and 1970s.
In 1980, it was increased to $100,000. According to the FDIC, "The increase to $100,000 was not designed to keep pace with inflation. Rather, it was in recognition that many banks and savings and loan associations, facing disintermediation in a high interest rate climate, had sizable amounts of large certificates of deposits (CDs) outstanding. The new limit facilitated retention of those deposits or replaced outflows from other deposit accounts with ceiling-free CDs."
In other words, the insurance limit was more than doubled, from $40,000 to $100,000, simply because there were a lot of depositors that carried large deposit balances due to high interest rates, and the FDIC wanted to help banks keep those deposits, rather than face disintermediation - withdrawal of funds in favor of other alternatives, like money market funds - and allow them to pay very high interest rates, which may have encouraged them to take excessive interest rate risk (and, in fact, was a contributing factor to the S&L crisis after the Depository Institutions Deregulation and Monetary Control Act of 1980 was passed).
Who held those $100,000 deposits in 1980? Well, the median family income that year was about $21,000, and the personal saving rate was about 11%, so the answer is probably only the very well-to-do. That means that the $100,000 limit didn't meet the original intent of protecting the average American family's savings; instead, it protected the wealthy, and as we discussed above, the cost was disproportionately borne by the average family.
Finally, in 2008, in response to the financial crisis, the limit was more than doubled again, to $250,000. Again, it protected large depositors - the wealthy, and institutional depositors (businesses and other financial institutions). And you can bet that when the next crisis rolls around, there will be another massive increase in the limit.
In fact, a friend told me that after the SVB and Signature Bank failures, he heard someone on a news show arguing that the $250,000 limit wasn't high enough. Who was making that argument? David Sacks, a tech venture capitalist and co-founder of PayPal, the kind of company that had millions of dollars deposited with SVB. Do you think perhaps his argument for a higher insurance limit was self-serving, and not in the interest of the average American family?
Okay, next, I want to talk about bailouts.
In discussing bailouts, I should mention that deposit insurance is, in essence, a "bailout before the fact." I'm okay with that in principle, since it's what deposit insurance was intended to do. But the higher the deposit insurance limit, the more risk the bank is encouraged to take, which creates a moral hazard. Set the limit too high, and the moral hazard becomes too great, and the bank takes on excessive risk, and makes bad decisions. Maybe that's why Silicon Valley Bank did some of the things it did.
When a bank does this, it's transferring risk to the other banks that aren't taking those risks, but are paying deposit insurance premiums ... except we now know that those banks aren't really paying the premiums, they're passing them along to their customers ... except we now know that they're disproportionately passing along the excess premiums, which we could also call the excess risk incentives, to their smallest depositors, the very people that deposit insurance is supposed to protect.
In other words, high deposit insurance premiums, in the event of a bailout, result in a massive transference of risk to small depositors.
It gets worse, however. As we now know (and it's happened way too often before), in the case of SVB and Signature Bank, even the uninsured depositors were made whole - in other words, they got an outright bailout. They were entitled to nothing under federal deposit insurance; the banks paid no premium on their behalf, and yet, they got the same benefit from the insurance fund as the insured depositors.
Why do I say "from the insurance fund?" Because that's where the bailout money came from! The government - FDIC, Janet Yellen, Joe Biden - all like to boast that it won't cost taxpayers a penny. (It actually will - more on that later.) But it will cost small bank depositors dearly, because in the case of SVB alone, 94% of its roughly $209 billion in deposits were uninsured, so the insurance fund has to cover about $194.5 billion of deposits that weren't entitled to one red cent of protection.
We saw a lot of this in 2008-09, and during the S&L crisis. Even worse, during those times, the failures were so widespread, the bailouts so prevalent, that the taxpayer eventually did have to pick up the tab for some of it, because the deposit insurance fund was insufficient to cover it all. (I'll talk more about that later, as well.)
So occasionally the taxpayer does have to pay, and in those cases, the risk is transferred to the taxpayer. But I'd say there's always some transference of risk to individual taxpayers. Why? Because banks pay income tax (credit unions don't - there's a very sound reason that I don't have time to explain in this post). And like most large organizations, big banks (the ones that would be most likely to cost the taxpayers money in the event of a bailout) avail themselves of loopholes that reduce their effective tax rate to a level much lower than you or I pay. Thus, if they ever do get bailed out, and it winds up costing the taxpayer, they've transferred their excess risk to the taxpayer.
It would appear obvious that the Treasury shouldn't be bailing out uninsured depositors, but their position in the case of SVB and Signature Bank is that these depositors are large corporations, and to not cover their deposits would undermine confidence in the U.S. banking system.
I'm going to throw the BS flag on that one. These are large corporations that make campaign contributions to the politicians who pressured Treasury to make the decision to cover those deposits, pure and simple. The only thing not covering their deposits would undermine is the confidence that, if they go ahead and deposit their money in another U.S. bank, and that bank fails, their uninsured deposits will be covered again. So they'll just keep depositing millions of dollars in a single bank.
In other words, we've set a precedent here, and as a result, de facto, there is no deposit insurance limit.
However, there is a limit on the premium paid into the fund. And that means that, sooner or later, when there is another systemic banking problem, the fund will be insufficient to cover all the deposits, and the taxpayer will pay the cost.
That is a massive moral hazard. What it says to large banks is, "Take all the risk you want. You're covered." What it says to huge corporations who want to be lazy and just park all their cash in one bank, rather than spreading it among different banks - or want to avail themselves of the same protections that the average American family enjoys, which was the original intent of deposit insurance, rather than assuming and managing risk, as huge corporations should be in the business of doing - is, "Go ahead and park your cash in one bank - all $500 billion of it, or whatever the amount. You're covered."
That moral hazard is the unintended consequence of the precedent set by bailing out uninsured depositors, which kind of sums up the title of this post.
Now, I mentioned that during 2008-09, and the S&L crisis, the insurance fund was insufficient to cover all the losses. Why, you may ask, would the Treasury set up an insurance fund that isn't enough to cover all the losses?
When Hurricane Katrina hit the Gulf Coast in 2005, the damage was far beyond anything ever anticipated or experienced in the region previously. And the insurance losses exceeded what insurers were able to cover, because their projections did not capture damage of the magnitude that Katrina wrought. That's why insurance companies now use hedging instruments related to weather events, buy reinsurance, etc.
Likewise, the insurance fund, as noted above, is set up to cover a "normal" expected level of losses, but not a crisis of the magnitude of the S&L crisis or the 2008-09 financial crisis, neither of which had ever been anticipated before. (I'd call them "once in a lifetime" events, except they both happened not only in my lifetime, but in my career.)
There are a couple of points to be made here. First, it would be prohibitively and probably unnecessarily expensive to set up the insurance fund to cover an absolute worst-case, S&L crisis or 2008-09 magnitude banking system event. The premiums would be very high, and that cost would be passed along to bank customers - again, disproportionately - and that level of coverage would only rarely be needed. It would be like property insurance companies charging premiums based on models that assumed a Hurricane Katrina-magnitude storm would hit the Gulf every year; nobody who lived there could afford insurance.
But this is the more important point:
The excessive level of deposit insurance creates a moral hazard that encourages the excessive risk-taking that results in these near-worst-case crises occurring every 20 years or so to begin with.
In other words, by setting the deposit limit so high, and by setting the precedent of bailing out uninsured depositors, and by setting another precedent that I'll address momentarily, banks are encouraged to assume outsized risk - in pursuit of outsized profits - that will eventually, when conditions are right (like a massive collapse in home prices combined with a lending model that required little equity and allowed questionable appraisals, as happened in 2008) result in a systemic banking crisis that will exceed the insurance fund's ability to cover it.
Since they do this in pursuit of outsized profits, they're actually transferring risk that should be borne by shareholders to depositors and taxpayers, yet another inappropriate transference of risk.
Now, what's that other precedent that I alluded to?
It's the concept of "Too Big to Fail." There is no magic threshold for TBTF, no minimum asset size. It's like the courts' definition of obscenity: "We'll know it when we see it." But we heard a lot about it back in 2008-09, when the government bailed out Washington Mutual, a $328 billion mortgage lender; Bear Stearns, a Wall Street firm that specialized in mortgage-backed securities; Lehman Brothers, another large Wall Street firm; and AIG, an insurance company that specialized in insuring the assets underlying collateralized debt obligations.
The concept was that, if these giant institutions were allowed to fail, it would threaten the entire global financial system and economy.
Well, let's see: 25 financial institutions failed in the U.S. alone in 2008. The U.S. unemployment rate ultimately reached 10% in 2009, and remained above 8% for 3 1/2 years. A total of 8.7 million jobs were lost from early 2008 to early 2010; it would take until mid-2014 to recover them. The housing market took a decade to recover. And the U.S. economy was in recession for 18 months, the longest and deepest downturn since the Great Depression. And as the U.S. goes, so goes the rest of the world, which didn't fare any better. So I'd say that even though we bailed out those institutions, it didn't do much to avoid the entire global financial system and economy being threatened.
Ah, the pundits say, but how much worse would it have been if the government hadn't intervened?
That's always the question, and I've addressed it before in this blog, always the same way. It's like those old Tootsie Pop commercials with the wise old owl, where the kid asks the owl, "Mr. Owl, how many licks does it take to get to the center of a Tootsie Pop?" The owl rips the wrapper off a Tootsie Pop and starts counting the licks: "One, two, three ..." then he bites into the center, and the voice-over says, "The world may never know."
So it is with the question of whether it's better to intervene and bail out banks (and other businesses, for that matter), or let them fail: the world may never know, because government always steps in and - "CRUNCH!" - takes the bailout bite.
Well, here's my proposed free-market solution. It would avoid the transference of risk from those who are in the business of risk-taking to those of us who shouldn't be, and keep the costs associated with risk where they should be.
- Treasury should announce that there is no more "Too Big to Fail." Period. And they should mean it.
- Treasury should make this clear to the banking system: if you take excessive risks, you will not be bailed out. The insurance fund will cover insured deposits, and that's it.
- Treasury should make this clear to the markets: stockholders, bondholders, and banking analysts, there will be no more "Too Big to Fail." If you're going to buy stock in a bank, or invest in its debt securities, do your research, look at their financials, analyze their management, scrutinize their risk, and then - and only then - invest ... at your own risk. If they fail, you lose your investment. We will not, under any circumstances, no matter how much Jim Cramer screams, bail them out.
- Treasury should make this clear to depositors: we will always, 100% of the time, cover all insured deposits, up to the insurance limit. We will never fail to do that. We will never, 0% of the time, cover a single penny of uninsured deposits. We will never fail on that promise, either. So if you insist on depositing $250,000.01, know that that last penny will be lost if the bank fails. If you insist on depositing $478 million (that means you, Roku), know that $477.75 million will be lost if the bank fails.
- Bank stock prices will probably fall, to a level that is more realistically commensurate with the risk the banks are actually taking. But after that market adjustment, stock prices in the banking sector will normalize.
- Banks' debt securities will probably get downgraded, to a level that is more realistically aligned with the risk the banks are actually taking. But as banks adjust their risk-taking, their debt ratings will be adjusted accordingly.
- Large depositors will move money around to different banks to ensure they remain under the deposit limit per account. This will likely result in a run on deposits in banks that have a high concentration of uninsured deposits, therefore it would probably need to be phased in over some period of time to avoid a liquidity crisis that would result in those banks failing. An alternative would be to backstop the liquidity crunch with a temporary liquidity facility, but it would have to be funded directly by those large depositors to avoid billing it to the banks, who would just pass it along to their customers, probably disproportionately. So maybe charge an excess insurance premium directly to those depositors who need it, just as some of us carry umbrella insurance policies over and above our homeowners' policies.
- Eventually - and this is the best news - banks would adjust their risk-taking behavior to a more reasonable level, making the banking system safer for everyone, resulting in fewer bank takeovers, fewer systemic crises, lower insurance premiums, lower fees, and higher deposit rates. Of course, lower risk-taking would mean lower returns to stockholders, but they're currently enjoying the transference of risk to depositors and taxpayers, when it should be borne by them.
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