Congressional Proposals for Heightened Deposit Insurance Broaden Government Intervention and Cost Taxpayers

The failures of Silicon Valley Bank, Signature Bank, and First Republic Bank do not warrant the expansion of federal deposit insurance. Continuously expanding deposit insurance creates moral hazard among the management of insured depository institutions and their depositors, which catalyzes bank failures.

There is extensive academic research concluding that deposit insurance has resulted in systemic risk in the banking sector. One study by Charles W. Calomiris and Matthew Jaremski shows the historical failures of deposit insurance and how it “increased risk by removing market discipline that had been constraining erstwhile uninsured banks.” They also cited several papers “suggesting that the moral-hazard costs of deposit insurance have out-weighed its liquidity-risk-reduction benefits.”

Even former President Franklin Roosevelt felt that deposit insurance “would lead to laxity in bank management and carelessness on the part of both banker and depositor” and “would be an impossible drain on the Federal Treasury.”

Critiques of Proposed Policies

On June 23, 2023, Ranking Member Maxine Waters (D-Calif.) and Reps. Bill Foster (D-Ill.) and Sylvia Garcia (D-Texas) of the House Committee on Financial Services participated in a Democrat-led roundtable discussion with three representatives of the banking industry and one academic to discuss options for federal deposit insurance reform. The discussion revolved around the Federal Deposit Insurance Corporation’s (FDIC) proposed “reforms” to the deposit insurance limit. The three options posited by the FDIC all include elevating the federal deposit insurance limit of $250,000 per depositor, per bank, per ownership category, by varying degrees.

An increase to the deposit insurance limit will allow bank managers to make riskier investments with deposits, knowing full-well that if the bank cannot meet a surge in deposit withdrawals and the bank goes under, the FDIC will be there to support depositors. This incites Congress to introduce slapdash legislation to claw back bank executive compensation, without fully acknowledging the currently existing federal and state laws that already allow regulators to remove executives from their roles and issue severe monetary penalties for gross negligence.

Rep. Blaine Luetkemeyer’s (R-Mo.) Small Business Stability Act (H.R. 3243) would grant the FDIC the authority to insure all noninterest-bearing transaction accounts for up to two months. To kickstart this program, boards of the FDIC and the Federal Reserve (Fed) would each need a two-thirds vote in favor of recommending this policy along with the approval of the Treasury Secretary, in consultation with the President. The regulators would have to determine that minimizing losses to the Deposit Insurance Fund (DIF) “would have serious adverse effects on the stability of the entire banking system” and the temporary guarantee would “avoid or mitigate such adverse effects.” Under the bill, the FDIC is allowed to disregard other provisions of statute that normally would require the agency to minimize the cost to the DIF. Not only will this bill result in increased assessment fees on banks, which the taxpayer will ultimately pay for, but this bill is a recreation of the Transaction Account Guarantee Program (TAG), which was created in the wake of the 2008 financial crisis. TAG was initially created by federal regulators using the “systemic risk exception” as authorized under the Federal Deposit Insurance Corporation Improvement Act of 1991 (P.L. 102-242).

Subsequently, the big-government provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203) codified TAG’s existence through 2012. Former Sen. Harry Reid (D-Nev.) sponsored legislation to extend TAG through 2014, but it was subsequently quashed by Senate Republicans because of the significant moral hazard implications and the risk of further entrenching the federal government’s foothold in the banking sector.

Rep. Adam Schiff (D-Calif.) also introduced a bill to expand deposit insurance. The Deposit Insurance Reform Act (H.R. 3928) would allow banks and credit unions to choose a higher level of deposit insurance with the caveat that higher assessment rates will be applied to banks and credit unions that elect to take the higher level of deposit insurance. This would apply to deposit accounts for businesses, including sole proprietorships. The bill cedes the authority to set the new deposit insurance levels to the FDIC and the National Credit Union Administration (NCUA).

Both the Schiff and Luetkemeyer bills will induce more moral hazard and increase systemic risk. Bank managers know that with more government insurance they can use more equity or deposits to take larger investment risks—it is a classic safety net. Simultaneously, depositors will not feel the need to evaluate or monitor the banks or credit unions holding their money.

Some academics have suggested an alternative to expanded deposit insurance could be to allow small businesses to bank directly with the Fed. This idea is a nonstarter because banking directly with the Fed would further destabilize the banking sector (especially among community banks that rely on core deposits) by shifting deposits away from banks and credit unions, and further centralizing banking services with the federal government. Additionally, personal privacy information could be exploited through a Fed account. Similar policy proposals have been pitched by Democrats, such as Sen. Sherrod Brown (D-Ohio).

Solutions

The systemic risk exception, which regulators used to bail out uninsured depositors at Silicon Valley Bank and Signature Bank, should be removed from statute. The existence of the systemic risk exception as an option for regulators creates its own moral hazard risks. GAO documented the moral hazard risks associated with the systemic risk exception as far back as 2010. In the GAO’s 2023 Preliminary Review of Agency Actions Related to March 2023 Bank Failures Fed staff “raised concerns about exacerbating moral hazard and potentially weakening the market discipline of many depository institutions” by bailing out uninsured depositors at Silicon Valley Bank and Signature Bank.

If bank executives were aware that regulators possessed the authority to fully insure all deposits, then this could have prompted the executives to make risky decisions, such as when Silicon Valley Bank removed their interest rate hedges and attempted to squeeze profits in the short term.

Other solutions for consideration include:

• Further deregulating reciprocal deposits 
  • In 2018, the Economic Growth, Regulatory Relief, and Consumer Protection Act (P.L. 115-174) largely removed reciprocal deposits from the definition of a “brokered deposit” to unleash more bank products that allow more deposits to be insured under the current deposit insurance limit. Currently, reciprocal deposits are considered “non-brokered” if they amount to no more than $5 billion or 20 percent of a bank’s total liabilities, whichever is less. These private sector alternatives protect depositors and avoid exacerbating moral hazard to the same degree as increasing the deposit insurance cap. Allowing banks more leeway to pursue these products could benefit both household and business depositors. 
• Promote bank sweep accounts
  • Businesses and individuals can take advantage of these private sector alternatives. For example, some community banks and regional banks offer insured cash sweep programs that allow depositors to distribute their cash around to different accounts “to money market deposit accounts at other FDIC-insured financial institutions” to earn higher interest and stay under the insurance limit. A heightened government backstop is not needed because the private sector is already innovating new products to benefit individuals and businesses. 
• Mark-to-market accounting for all bank assets
  • Simple accounting tweaks, such as marking-to-market the entirety of a bank’s securities portfolio, can offer transparency to bank shareholders, bondholders, and depositors. Charles Calomiris and Phil Gramm have proposed this idea.