NRPLUS MEMBER ARTICLE T he Federal Deposit Insurance Corporation (FDIC) released a report last week detailing potential deposit-insurance reforms to prevent the sort of bank runs that led to instability within several large regional banks this year. However, by providing serious consideration to unlimited, and the targeted expansion of, deposit insurance — policies that would enable the federal government to guarantee bank deposits regardless of amount — this report may as well have provided a blueprint for guaranteeing future bank runs and continued instability in our financial system.
Deposit insurance depends on market discipline, in which individual depositors hold their banks accountable by choosing to utilize their services. Market discipline is an essential element of the traditional banking system since depositors choose to receive services from the most competitive institutions. This incentivizes banks to assume calculated risks because unhealthy institutions are eventually superseded by healthy ones. When deposit insurance limits are raised, or removed, it diminishes market discipline since extra backstops from the federal government reduce the need for depositors to exercise a similar amount of discretion when choosing where to bank.
When market discipline is weakened by such government backstops, it creates a moral hazard for banks, which are incentivized to engage in risky behavior knowing guarantees to depositors will make them more tolerant, and possibly ignorant, of potential mistakes. During the last expansion of deposit insurance following the 2008 financial crisis, depositors felt relaxed by the higher backstop and were less likely to withdraw funds from unhealthy banks. Depositor complacence functions as an effective subsidy for banks to assume additional risk, such as the overaccumulation of uninsured deposits, or the overconcentration of assets in a particular sector, both of which contributed to this latest banking crisis.
If market discipline cannot ensure banks operate in a prudent manner, financial regulators must assume this responsibility, requiring additional oversight authorities to handle increased risk in the system. However, further regulation and oversight is not always enough to prevent instability — the savings-and-loan crisis, 2008 financial crisis, and even today’s instability all represent the relatively few instances where financial regulators still could not perceive systemic risks within the banking system. Raising or removing deposit insurance limits will almost certainly increase systemic risk, justifying further oversight by financial regulators, but without similar guarantees of averting future instability within the banking system.
These downside risks are not even justified by their purported benefits. In 2022, just 1 percent of total deposit accounts had more than $250,000, the current limit on deposit insurance. Similarly, uninsured deposits account for well over 50 percent of all deposit accounts at just 22 banks out of 4,706 institutions, a figure that once included Silicon Valley Bank, Signature Bank, and First Republic Bank. There are a plethora of options by which high-net worth depositors can safely insure over $150 million across multiple banks.
This handful of large regional and national banks would be subsidized by smaller, community banks when they assume too much risk and the federal government offers guarantees to their depositors. All banks must contribute to the Deposit Insurance Fund (DIF), administered by the FDIC, that has sole discretion when determining which institutions must replenish the DIF when it is expended. After 2008, many community banks were required to contribute to the DIF when it was utilized to guarantee depositors at larger firms such as Lehman Brothers. Banks might also pass their charges off to customers via higher prices or reduced services, investors via lower stock returns, and employees via cutbacks to compensation.
In other words, if deposit insurance limits are raised or removed, it would be a regressive tax that benefits a few banks and their depositors at the expense of many smaller stakeholders. Administrative adjustments to deposit insurance without meaningful penalties or reforms could be interpreted as expanding the infamous “too big to fail” umbrella to all banks regardless of size, risk, or fault, creating a crisis of credibility for the FDIC and other financial regulators.
It is no wonder a diverse amalgam of external financial regulatory experts have raised concerns about these policies, and the legislators considering these recommendations from the FDIC should take notice too. Depositors are the first line of defense against future bank runs; raising or removing deposit-insurance limits chips away at their influence and raises the potential for continued instability.