"Silicon Valley Bank's failure makes many Americans grateful for deposit insurance, which protects accounts holding $250,000 or less. But the SVB episode also illustrates the dangers of deposit insurance. A banking system dominated by government insurance, plus too-big-to-fail protection that effectively insures all deposits at the largest banks, lacks essential market discipline, is systemically unsafe, is more likely to see episodes like SVB's failure, and is more costly to taxpayers and bank customers.
Historically, unprotected well-informed depositors, especially other banks, gauged and responded to each bank's risk, creating an incentive for banks to manage risk responsibly. Uninformed depositors -- like those now at risk at SVB -- were free riders on informed discipline. Now, informed depositors can easily get around the $250,000 limit on insurance, which eliminates their incentive to monitor banks. The recent disappearance of the interbank loan market means that banks don't monitor each other to gauge creditworthiness as short-term borrowers of reserves either. That leaves only bank regulators to mind the store, and they often lack incentives and knowledge to measure and punish risk on a speedy basis. That's how predictable messes like SVB happen.
How do informed investors skirt the limit and get all their deposits insured? In two ways. First, they deposit millions at a bank participating in the Certificate of Deposit Account Registry Service, or Cdars, which swaps deposits among many banks so that a depositor can have millions covered with all transactions handled through a single lead bank. Second, they deposit funds at a too-big-to-fail bank, where all deposits are effectively riskless. Title II of the Dodd-Frank Act of 2010 lays out how the Treasury bailout would occur and be funded.
A century ago, bank regulators saw their job mainly as examining banks and forcing them to publish accounts in the local newspaper so that informed lenders and depositors could act on accurate information. Runs on deposits occurred under the old system, but the record of fragility has been exaggerated and misunderstood, and the U.S. historical experience was an extreme case. Most countries had occasional bank failures but rarely suffered a systemic crisis. Canada never did. The U.S. was prone to systemic crises because of idiosyncratic factors of regulation. Branching restrictions, which weren't eliminated until 1997, created a system of thousands of small, isolated and undiversified banks and a pyramidal liquidity management system that sometimes collapsed under stress.
Deposit insurance was absent from nearly all other countries' banking systems before 1980, and from the U.S. (with some temporary exceptions) until 1933. It was adopted for political reasons, and it hasn't been a stabilizing influence. Virtually every academic study of deposit insurance shows that it promotes, rather than reduces, banking system fragility, with major costs borne by the insurers -- which means ultimately by insured depositors and potentially taxpayers. The popularity of deposit insurance reflects public ignorance about its costs and about how a disciplined, uninsured banking system could operate as an alternative.
Informed depositors respond to troubles at banks early, with withdrawals that pressure banks to reduce their riskiness. When discipline resulted in bank failure, that often had a bright side: Risky banks in receivership were prevented from digging deeper holes at depositors' expense. Consequently, for most of U.S. history, depositors' losses on failed banks were small.
Even the tardy uninformed discipline exerted on SVB today likely will have a similar effect. Based on publicly available data about SVB's portfolio, its deposits and its capital footings, the cost of bailing out uninsured depositors is likely to be very little, because the run on SVB happened before the bank became deeply insolvent.
Generous deposit insurance, with the amplifications of Cdars and too-big-to-fail protection, has been undermining market discipline for many years. A new factor is the Federal Reserve's quantitative-easing and interest-on-reserves policies, which have eliminated the interbank market for borrowing reserves, further reducing incentives for institutions to monitor one another's risks and punish transgressors by denying them access to credit.
It's clear that many SVB clients lacked financial sophistication. SVB attracted companies to hold deposits greater than the $250,000 insured maximum by paying roughly 0.6 points greater interest than its competitors. That should have signaled inordinate risk taking (via long-duration securities holdings). But depositors saw only opportunity, not risk -- practically the definition of an unsophisticated depositor.
One CFO told me he wasn't so much responding to the higher interest rate as doing what he saw every other Silicon Valley startup doing.
He had no explanation -- other than ignorance -- for why he didn't protect his money via Cdars or a too-big-to-fail bank.
One might be forgiven for wondering whether IT entrepreneurs learn anything in business school. (Don't ask me; I'm conflicted on that one.)
This episode points to a continuing failure of regulatory discipline, which lacks the incentives and smarts of the market, to substitute for market discipline. It also points to the need for business managers to learn more about banking, and for the Fed to learn that its own monetary-policy mismanagement for many years has lots of consequences for reducing financial stability. Those consequences include the insidious elimination of interbank discipline by ending the last vestige of informed discipline on imprudent risk management by banks.
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Mr. Calomiris is director of the University of Austin's Center for Politics, Economics and History and a professor of financial institutions at Columbia Business School. He served as chief economist of the Office of the Comptroller of the Currency, 2020-21." [1]
1. Deposit Insurance Encourages Bank Failures
Calomiris, Charles W. Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 14 Mar 2023: A.19.
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