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Is Deposit Insurance a Moral Hazard?

The FDIC came out with an interesting (at least to me, an ex-banker) study entitled: “Options for Deposit Insurance Reform”. Most of us haven’t thought too much about banks failing and deposit insurance for the last couple of years, that is, until the Silicon Valley Bank and Signature Bank failed earlier this year.  Suddenly, it was back to 2007, or 1990, or whatever you remember as a banking crisis.

The FDIC was created in 1933 to prevent the financial hardships caused by bank failures. Prior to that, there was only the word of the bank that it was sound. When a bank failed, people lost everything. The Deposit Insurance Fund is replenished as needed by assessments on all banks.

Initial FDIC deposit insurance coverage was $2,500 per account. That’s now up to $250,000 per account. As we found out from Silicon Valley Bank, there are many larger uninsured deposits in banks. Uninsured deposits are disproportionately concentrated in the largest banks.

The FDIC’s mandate is to prevent financial hardships at the least cost. One way to do that is not all deposits are covered by insurance.

In the study, the FDIC defines “Moral Hazard” as the “incentive to take on greater risk as a result of being protected from the consequences of risk taking”. If the FDIC guarantees 100% of deposits, the theory goes, bankers may be tempted to lend/invest too aggressively. On the other hand, with limited insurance coverage (as it is now) and today’s lighting fast communication, word that a bank is having problems gets around quickly and can cause a crisis as depositors try to withdraw their money.

Another option that the FDIC study mentions is “Targeted Coverage”. That means that maybe accounts used for payment purposes are covered, while others are not. The thinking here suggests that we want to be sure that payroll accounts or bill paying family accounts are protected, while savings might not be.

There are only a few ways for banks to fail. The most recent Silicon Valley bank situation is the same as the savings and loans in the 80s, they took deposits short-term and then invested them long term at fixed rates. Silicon Valley Bank had lots of uninsured deposits and took great investing risks, so maybe that Moral Hazard theory doesn’t hold up too well.

Another way for banks to fail is making too many bad loans or investments – that is reminiscent of the 2007 recession when banks were overly aggressive in real estate lending.

Rather than look to deposit coverage tweaks, regulators ought to look at rapid growth and try to rein that in.  It seems un-American to be against growth, but the rapid growth of Silicon Valley Bank and Signature Bank indicated future problems.

Banks are still needed today, but there’s plenty of competition in every profitable area.  Maintaining an edge in banking means, in addition to technology, staying connected to customers, keeping good employees, and just don’t screw up!


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