Uninsured depositors remain a ticking time bomb for the U.S. banking system

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The failures of three sizable banks in March and April exposed major weaknesses in bank regulation. Who did what to whom, and when–a favorite Washington game–is currently playing out. What has received less attention is the major role that uninsured depositors played in these bank failures–and how uninsured deposits remain a major source of instability for the U.S. banking system.

Deposit insurance in U.S. banks is provided by the Federal Deposit Insurance Corporation (FDIC); for credit unions, it’s the National Credit Union Administration. The maximum amount covered is $250,000 in a bank account (although there are ways to have multiple covered accounts). For most households, that is more than enough.

Nevertheless, uninsured deposits are currently around 40% of all deposits (up from only 20% three decades ago), and these uninsured deposits are a lurking problem for banking stability–especially in an era of online banking. Uninsured depositors are almost always slow to recognize the financial problems of their banks. But when they do, their reactions are fast and massive. And their withdrawals may well inspire large withdrawals at other banks, with highly disruptive consequences for the U.S. economy: contagion risks are real.

The best way to address this problem is to eliminate this source of instability: extend deposit insurance to all deposits and depositors, regardless of amount. Since the insured deposit amount maximum is set by statute, this will require Congressional action. It will also require the FDIC to increase deposit insurance premiums and to become much more serious about levying premiums on a risk-adjusted basis–as any sensible insurer ought already to be doing. At a minimum, since the consumer price index has increased 40% since the fall of 2008 (when the currently applicable $250,000 limit was established), just an adjustment for inflation would call for an increase to $350,000.

An additional argument in favor of 100% deposit insurance is that bank regulation could become more transparent. Right now, it is highly secretive–because regulators fear that bad news will cause destructive and contagious bank runs. But if all depositors are insured, that risk is no longer a factor.

Such suggestions for 100% deposit insurance are always greeted immediately with claims that this expanded coverage will increase “moral hazard” on the part of bank managements: that banks will engage in more risky behaviors because their large-denomination depositors (who would now be insured) won’t care. The problem with this “moral hazard” argument is that, as the Silicon Valley Bank experience in March vividly illustrated, the large uninsured depositors currently don’t care–until the last minute. Depositors–whether insured or uninsured–are simply not good monitors of bank managers and thus are not effective restraints on banks’ behaviors.

Instead–and even if 100% deposit insurance is not embraced–banks should be required to issue subordinated debt. These bondholders, who would be holding longer-term debt and who thereby couldn’t run, would be more sophisticated and knowledgeable about banks and banking than are depositors. Since the bondholders would be exposed to losses after the bank’s equity capital has been exhausted, the terms of the bonds should provide the bondholders with governance rights–so that these liability holders would have the ability, as well as the incentive and the expertise, to monitor senior bank managers and exercise restraints as needed.

This idea of mandatory subordinated debt (or some rough equivalent) was widely discussed after the financial crisis of 2007-2009. However, the discussion petered out, and at year-end 2022 the U.S. banking system had only $65 billion in subordinated debt outstanding–less than 0.3% of total assets. This is surely an appropriate time to revive that discussion.

Another argument that is offered in opposition to 100% deposit insurance is that the beneficiaries will be high-income households: Since deposit insurance may not be accompanied by appropriate risk-based insurance premiums, the rich will be subsidized by the general public (as is currently true, for example, of flood insurance). But this argument ignores the basic instability costs for the banking system that uninsured deposits create.

If 100% deposit insurance is too much to swallow, then other measures that reduce the flighty nature of uninsured deposits are needed. The guiding idea should be that the act of withdrawing a large deposit from a bank has potentially negative consequences for others. This is a standard “negative externality” or spillover effect, much like pollution or congestion. It needs to be addressed through measures that would slow down withdrawals of uninsured deposits and/or make them more costly. A number of such proposals have recently surfaced and are worthy of serious consideration.

Further bank runs at other banks have not developed in the past month or two. Perhaps the system is stable–for the moment. But the basic flighty nature of those uninsured deposits–and the consequent fragility of the U.S. banking system–remains. The system is likely to be stressed later this year by the cratering of the commercial real estate market and the consequent write-downs of banks’ loans on these properties.

The best time to fix the roof is when the sun is shining.

Lawrence J. White is a professor of economics at the NYU Stern School of Business. He was a federal regulator of the savings and loan industry from 1986 to 1989.

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