Bank runs are different now

Good morning. If all goes as expected, today marks the last Federal Reserve rate increase of this cycle. But much has not gone to plan lately. The data, as ever, are equivocal. Yesterday’s Jolts report showed job cuts rising, job openings dropping and the quits rate nearing pre-pandemic levels — all signs of cooling. But last week’s employment cost index suggested wage growth re-accelerated in the first quarter.

Our bet, and the market’s, is that the central bank is done after today. We’ll be watching for the Fed’s assessment of the data, and of the credit crunch that is supposedly under way. Let us know what you’ll be looking for: robert.armstrong@ft.com and ethan.wu@ft.com.

Fixing deposit insurance

Three good-sized US banks have failed this year, and the government organisation tasked with cleaning up after bank failures, the Federal Deposit Insurance Corporation, thinks the system could use some reform. In particular, the FDIC says we need to rejig the deposit insurance system. It is probably right.

What’s wrong with the status quo? It is important that bad businesses be allowed to fail, and Signature, Silicon Valley and First Republic were all demonstrably bad businesses. If the ensuing mop-up requires some costs to be socialised through the FDIC insurance fund, maybe that’s OK.

The FDIC’s worry is that technology has increased to potential for irrational, destructive and contagious bank runs. A drastically faster speed of communication and the ability to withdraw money on your phone “exacerbate the potential for panic-driven runs”. That, paired with a 75-year high in the uninsured share of domestic deposits, makes the banking system look fragile. This concern is legitimate. People are lazy; if you make it much easier for them to join a run on a bank, more of them will. Silicon Valley lost $40bn in deposits, 23 per cent of its total, in a single day in March. It took Washington Mutual nine days to lose $16.7bn, or about 9 per cent of deposits, back in 2008. Something has changed.

So why not just insure all deposits? The FDIC thinks that deposit insurance “can result in moral hazard and can increase bank risk-taking” and that the threat of bank runs is an incentive for prudence by bank executives. As we have argued before, while this is probably true, it’s not clear how true.

No bank CEO wants to end up like the hapless Greg Becker and James Herbert, the leaders of Silicon Valley Bank and First Republic, respectively. They lost their reputations (and presumably much of their wealth) after bank runs shuttered the two banks. But in both cases, gross mismanagement of interest rate risk might well have destroyed the groups even if depositors had not run. Both were facing a situation where their liabilities cost more than their assets yielded. Insolvency was a clear possibility.

To put the point another way, management teams in every business have an incentive to be prudent, in that if the business fails they get fired. The question is whether bank managements have an additional incentive, provided by the possibility of a run by uninsured depositors, that makes them even more prudent. The FDIC acknowledges this point.

Although unlimited deposit insurance removes depositor discipline, it need not reduce overall market discipline on a bank from non-deposit creditors, such as debt holders and stockholders. It is even possible that non-deposit creditors would perceive themselves to be at increased risk of loss under a system of unlimited deposit insurance coverage and have greater incentives to exercise discipline.

While it makes sense to think the threat of runs has some effect on banker behaviour, the chequered history of banking makes us wonder how strong the influence is. Reading between the lines of the report, the FDIC seems to have the same doubts. In the quote above, for example, it undercuts its own point about market discipline by acknowledging other pressure from stakeholders. It repeats the tic again in this point about the costs of unlimited insurance to the FDIC’s deposit insurance fund:

FDIC losses would be higher in a failure, other things equal, because there would be no uninsured depositors to take loss. Failures may be less costly if unlimited deposit insurance prevents costly bank runs or more costly if it allows risks on bank balance sheets to go unaddressed for long periods of time.

We reckon the real problem with unlimited insurance is that it isn’t terribly clear what would happen. It could be costlier than the current system, or not; it could reduce useful depositor discipline, or not. But from a regulator’s perspective, such uncertainties are what make the solution undesirable. And that’s fair. Institutional conservatism is probably a good thing with bank regulation.

The FDIC’s favoured fix, called targeted coverage, is a narrow expansion of deposit insurance to cover business payment accounts. The idea is that safeguarding non-interest-bearing checking accounts would ballast financial stability without putting the public on the hook for insuring the entire deposit base. As SVB was failing, a big fear was that half of Silicon Valley would wake up on a Monday unable to make payroll. Targeted coverage would allay this. It could even create something of an early warning system for bank runs, as depositors flee from one, uninsured side of a bank to the other, insured side.

The FDIC is somewhat vague on the details; would business payment accounts enjoy unlimited insurance, or merely a high insurance limit? (it estimates that a $2.5mn limit “would likely cover payroll for a large proportion of small- and medium-sized businesses”.) And it admits the implementation would be hard. Banks could try to blur the line between checking and savings accounts by, for example, offering rewards on funds held in checking or giving cheaper loans to businesses with insured funds.

Nevertheless the FDIC sees targeted coverage as the best financial-stability bang for its incrementalist buck, a big improvement without the risks of unlimited insurance. Yet that also means its preferred reform would not put to bed the issue it identifies, of digital bank runs in an increasingly uninsured system. Plenty of deposits will remain in uninsured accounts, and while some may flee to insured accounts in a bank panic, others could head for the door.

We think this targeted coverage experiment is worth trying. But there’s no avoiding the choice between accepting some run risk or accepting the uncertain costs of universal insurance. In banking, it’s always trade-offs all the way down. (Armstrong & Wu)

The FDIC’s $50bn loan to JPMorgan

As we noted yesterday, JPMorgan’s purchase of First Republic was funded in part by a $50bn fixed rate, five-year loan from the FDIC. The loan was key to the deal. In taking on First Republic, JPM assumed a lot of longish-term fixed-rate exposure. Having a chunk of fixed-rate funding cuts the risk of that exposure significantly. Asked what it was paying for the loan, however, the bank declined to say. So did the FDIC. I asked them both again yesterday, and they still don’t want to say, or comment on why.

My guess is that both JPM and the FDIC are worried about the political climate. People with one axe or another to grind are looking for a reason to talk about bailouts and handouts to big banks. A low rate would give them something to point to, ignoring the fact that the rate is part of a larger package. Make the loan more expensive, and the bidder will demand a bigger discount on the assets, and so on.

The total cost of the bid, including the cost to the FDIC of providing financing, is theoretically captured in the $13bn estimate of the cost to the deposit insurance fund. But without access to the models and assumptions used to arrive at that estimate, however, stakeholders in the banking system deserve all the basic information about the deal. Those stakeholders include bank investors, other banks which contribute to the insurance fund and taxpayers who ultimately stand behind the FDIC. Is there a possibility of confusion? Sure, but that has to be weighed against suspicions aroused by keeping the rate a secret. The rate on the loan should be part of the public record.

One good read

Alphaville’s inimitable Bryce Elder on Hindenburg Research and Carl Icahn.