How Congress can prevent another banking crisis

The failure of Silicon Valley Bank continues to reverberate through the financial markets, threatening the first banking crisis since 2008. Congress can prevent another crisis by requiring that all bank deposits be insured, and that depositors pay for their insurance.

An adage in banking is that there are two kinds of countries: those that have deposit insurance and know it, and those that have deposit insurance but just don’t know it yet.

In the United States, there are two kinds of accounts. Accounts up to $250,000 are insured as a matter of law. But as a matter of practice, accounts over this limit are often insured as well.  Last week, all deposit accounts at both Silicon Valley Bank and Signature Bank were guaranteed by Treasury Department fiat.

Should uninsured depositors be bailed out? Banking policy is not a morality play, so bailouts should be analyzed in terms of their effects on incentives and behavior. To anyone who remembers the 2008 crisis, the mantra that bailouts create moral hazard should be familiar. If depositors know they will be made whole, they won’t take care in choosing where to deposit their money. As a result, excessively risky banks will be subsidized at a cost to the financial system and to taxpayers.

This argument may be sound in theory, but it is probably not that important in practice. Bank shareholders have strong incentives to monitor bank risk. For example, the shareholders in Silicon Valley Bank are likely to lose everything.

Other unsecured creditors in a bank, such as bondholders or holders of commercial paper, are also likely to suffer losses in the event of a bank failure. Therefore, the cost of bailouts to the banking system is measured in the loss of additional monitoring by uninsured depositors.

How much do uninsured depositors monitor their bank for financial safety and soundness? The business customers at Silicon Valley Bank entrusted their deposits to a local bank with a stable reputation that had been around for 40 years. Most businesses likely do the same, as they should. Businesses are looking for a place to park their cash for operations where it won’t lose value.

As a matter of policy, it makes more sense for businesses to spend time making products and services, rather than investigating changes in the financial condition of their bank. At the same time, at the first sign of trouble in a bank, it is rational and easy for businesses and other uninsured depositors to switch banks, so depositors can trigger a “bank run” even when a distressed bank is ultimately solvent.

For these reasons, it makes sense to insure all bank depositors.

That said, the current way we insure depositors is haphazard and ineffective. Large depositors are never completely sure if they are insured or not. For example, Treasury Secretary Janet Yellen recently announced that not all uninsured deposits will be protected, only deposits at banks that pose a systemic risk. So large depositors still have an incentive to panic and withdraw their money from fundamentally solvent banks, and large banks stand to gain deposits solely based on their size.

In addition, the cost of insurance isn’t borne by large depositors. When the FDIC has to make payments to large depositors of a failed bank, it pays for the funds through assessments of other solvent banks based on their insured deposits. 

Instead, Congress or the FDIC should require that all deposits above $250,000 be insured. The FDIC currently assesses all banks a fee to maintain its Deposit Insurance Fund. This fee could be increased to cover all bank deposits. Banks should pay a risk-based fee because they are the ones determining the level of risk. Banks, in turn, would pass along part of this cost to depositors. In this way, businesses would also pay for their deposit insurance, but without the need for any structural change to the existing system. 

Deposit insurance should be limited to direct bank customers, and the practice of allowing financial intermediaries to aggregate and broker deposits, so as to chase higher interest rates, should be severely curtailed or eliminated.

Banks and regulators will make mistakes, and banks should be allowed to fail. We need a system in which shareholders and debtholders bear the cost of failure, depositors are made whole and don’t panic, and banks and depositors pay for the insurance they receive at rates that are proportional to their risk.  

Prasad Krishnamurthy is a professor of law at U.C. Berkeley School of Law.