Insuring all deposits would create a safer, fairer banking industry #IndustryFinance

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Ever since the 2008 financial crisis, and especially since the untimely 2023 demise of Silicon Valley Bank, First Republic and Signature Bank, there has been much gnashing of teeth among bank “experts” — regulators and their academic enablers — over how to best inoculate banks from the twin scourges of runs and bailouts.

To me, the solution is both obvious and simple; we should explicitly extend Federal Deposit Insurance Corp. coverage to all deposits, including those exceeding $250,000. This solution is almost uniformly rejected by those previously mentioned experts, but their arguments are deeply flawed.

Objections to full deposit insurance center on the problem of “moral hazard.” Many experts allege that if all deposits are insured, depositors will make no effort to differentiate sound banks from troubled ones. This, they contend, will enable troubled banks to assume more risk, knowing that if they win, shareholders will profit; but if they lose, it is taxpayers who will pay for a government bailout.

At first, this might sound logical. It appeals to our sense of fair play; those who make bad financial decisions should suffer the consequences and taxpayers should never pay for private mistakes. But to me, this view is mistaken on at least two fronts.

First, to my knowledge, taxpayers have never paid for the bailout of a U.S. commercial bank. It is the banks themselves who have always (eventually) paid for bank bailouts, mainly through FDIC assessments. To be sure, the Federal Reserve does often lend to banks needing liquidity. But this is not a bailout. This is just the Fed doing its job.

As MIT economist Deborah Lucas observes, “prospective costs to taxpayers are small, even during a severe financial crisis. The direct costs fall largely on strong banks, which through the system subsidize weaker ones.”

In its recent final reportthe Congressional Budget Office revealed that the commercial bank rescue programs (TARP, etc.) undertaken in the financial crisis eked out a profit for taxpayers although losses were sustained on some mortgage programs and aid to AIG, General Motors and Chrysler.

In fact, the whole “heads I win, tails you lose” argument is a big canard, at least when applied to U.S. banks. In a typical bailout, equity holders are wiped out — mainly through dilution — so the risk-takers don’t really “win.”

A second, and far more important flaw in the “moral hazard” argument is the false premise that private depositors — even sophisticated ones — are capable of effectively differentiating between those banks that will fail and those that won’t. After all, Silicon Valley’s depositors were the definition of “sophisticated.”

Think about it for a minute. How could any depositor have been expected to foresee the run at Silicon Valley when an army of so-called experts whiffed? Wall Street equity analysts missed it. Moody’s and S&P, always reliable lagging indicators of credit problems, missed it too.

And, of course, regulators missed it. As is recounted in the Fed’s admirably candid postmortem of Silicon Valley’s demise, more than a dozen examiners were embedded full time at the bank with access to all of its confidential information. If these ostensibly competent professionals could not see a freight train barreling toward them, how could any depositor on the outside have been expected to spot it and jump aside?

It is very much to the point that many of these experts had identified fundamental weaknesses at Silicon Valley prior to the run. The bank’s imprudently long bond portfolio was staring everyone in the face. But it is easy to identify deficiencies in a bank. It is another thing entirely to predict that a particular bank is doomed to imminent failure. After all, many banks had imprudently long bond portfolios.

The point is that despite Silicon Valley’s many deficiencies, it was virtually impossible for anyone to predict a fatal run. In other words, while we can explain in retrospect why Silicon Valley suffered its run, it could not have been foreseen. Runs are irrational, and unforeseeable by definition.

For the unfortunate First Republic, there is no rational explanation for its run, not even in retrospect. Its run was pure panic and contagion.

It seems to me that moral hazard implies intent. That is, the moral hazard standard requires that one knows when one invests in or lends to an institution that there is a strong probability of failure that justifies the excess expected return. Either that, or management is aware of such severe fundamental issues that they execute a “Hail Mary” play to save themselves.

Neither of these was true of SVB’s shareholders (who lost everything) or of its depositors. Nor was it true of bank investors in the 2007-2008 financial crisis. It was sickeningly true of investors and depositors in the 1980’s thrift crisis.

A compelling case in favor of full deposit insurance is that it would help balance the immense regulatory advantage held by our biggest banks over our smaller ones. As things stand now, every corporate treasurer knows that our government would never let depositors incur a loss at a systemically important financial institution. It is an easy decision to bank with these giants rather than take a risk with smaller banks whose large deposits do not have the same de facto guarantee.

I will admit to a strong bias in favor of our diverse banking system. Though difficult to prove, I believe that America’s endowment of small- and medium-size banks has been an immense benefit to us compared to other nations in financing small entrepreneurial businesses and serving local communities. Even though technology may be driving banks inexorably toward consolidation, I believe that we should do what we can to encourage smaller banks by providing them with at least a level regulatory playing field. Full FDIC insurance would help them survive and, hopefully, prosper.

It is ironic, to say the least, that our policymakers delight in disparaging our “too big to fail” banks and the concentration of the banking industry while at the same time driving business away from small banks and into the giants.