Last week, Federal Reserve Bank of Dallas President Lorie Logan gave a speech titled, "A level playing field for deposit insurance," which discussed increasing the FDIC deposit limit and other means of preventing bank deposit runs. The talk took place at a conference with the theme, "Exploring Conventional Bank Funding Regimes in an Unconventional World." Discussing "The importance of bank funding," she tells us, "Funding risk is both one of the oldest challenges in banking and one of the most timely. The most basic activity banks do is transform deposits into longer-term investments. Banks accept deposits, promise to return them whenever depositors want and invest in the meantime in less-liquid assets, such as loans that finance investment and fuel economic growth. So, as I'm sure the panelists in our history session this afternoon will discuss, bankers have long understood the importance of being prepared to meet withdrawals -- and of maintaining depositors' confidence so they don't withdraw money based on unfounded fears."
Logan explains, "But as we saw in 2023, maintaining depositors' confidence can be challenging in today's highly networked society that allows bank runs to propagate with unprecedented speed. Now that banking conditions have stabilized and the immediate pressures banks felt last year have passed -- though we should always remain watchful for any risks that may emerge -- it's a good time to consider whether adjustments in banks' liquidity risk management or in related public policies can support a strong and vibrant banking system in the modern environment."
She comments, "From my standpoint, there are three main ways to ensure sound liquidity risk management in banking. First, regulations can require banks to hold a certain amount of liquid assets, or banks can choose to do so voluntarily. This approach is important, but relying exclusively on it would have a drawback. By limiting the amount of liquidity transformation banks do, this approach limits the amount of banking they do. Second, as a complement to holding liquid assets, bankers and regulators can ensure banks have reliable and ready access to contingent funding sources. Contingent funding can come from private markets and from central bank backstops such as the Federal Reserve's discount window and Standing Repo Facility or from similar facilities."
Logan continues, "And third, banks and regulators can work to stabilize the deposit and funding base. For example, diversifying deposit sources can make a bank's funding more resilient. And deposit insurance can reinforce customers' confidence that their money is safe, thus preventing bank runs and limiting the potential liquidity outflows that banks may need to meet. These three approaches interact. Buffers of liquid assets and sound plans for contingent funding can reassure depositors and prevent runs, accomplishing some of the same goals as deposit insurance. And to the degree deposit insurance succeeds in preventing runs, banks may not need as much access to liquid assets or contingent funding."
She states, "In my view, a level playing field is achievable when it comes to deposit insurance, but that could require some change. Right now, a couple of factors related to deposit insurance come together to give the largest banks a potential advantage in attracting deposits. Federal insurance coverage is limited to $250,000 per depositor. That limit is supposed to give small depositors confidence while creating incentives for larger depositors to investigate their banks' condition. While large depositors could theoretically provide helpful market discipline, they also often perceive -- rightly or wrongly -- that some banks are too big to fail and that the government will bail out those banks or their depositors in a crisis. Such perceptions undermine market discipline and tilt the playing field toward big banks."
Logan states, "When I checked recently, several of the country's biggest banks were offering interest rates of just 1 to 6 basis points on a standard savings account. How many community banks can attract deposits at rates like that, when money market rates are over 500 basis points? Of course, there are many reasons why the largest banks may be able to pay lower interest rates than other banks. For example, some customers may value these banks' wide range of capital markets, settlement, custodial, international and other services or their extensive branch networks."
She adds, "But the evidence of a tilt goes beyond interest rates. Amid the severe banking stresses in early 2023, we heard many reports of depositors pulling their funds from smaller banks and moving to the largest ones. Just in the second week of March 2023, deposits at the country's 25 largest banks rose $113 billion, while deposits at all other domestic banks fell $172 billion. The shift was significant enough that executives at several of the largest banks mentioned it in their quarterly earnings calls."
Logan then says, "If you step back and look at how deposit insurance works, these actions by depositors aren't surprising. And although the flows to larger banks ebbed as banking conditions calmed, the underlying incentives remain. Especially when it comes to business accounts, $250,000 isn't such a large deposit. A small business employing 110 people at the median wage would need $250,000 in its checking account just to cover a biweekly payroll. What small business owner has time to conduct regular, thorough checkups on a bank's health? So, many depositors prefer to bank at institutions where they don't have to think hard about whether their funds are safe."
She explains, "And there's an important exception to the $250,000 limit. If a bank fails and the Treasury secretary and the boards of the FDIC and Federal Reserve agree there's a serious threat to financial stability, the FDIC can cover all deposits, even those above the limit. The government makes no advance commitments about when it will invoke that systemic risk exception. The exception has sometimes been applied to cover uninsured deposits at relatively small banks, such as when Silicon Valley Bank (SVB) and Signature Bank failed in 2023. Still, most depositors didn't foresee that action. If they had, they probably wouldn't have run on SVB and Signature in the first place. By contrast, while the government has not provided a formal guarantee to the eight U.S. firms designated as Global Systemically Important Banks, or G-SIBs, most market participants think it's pretty unlikely the authorities would let those firms' depositors lose money. After all, these banks are officially systemically important."
Logan then states, "Conceptually, there are a couple of possibilities for restoring balance. Regulators could adopt even tougher regulations on the largest banks. But such regulations could put a drag on the economy by raising big banks' costs for some of the unique and critical intermediation services they provide. Or, authorities could increase the deposit insurance limit so that deposits would be more equally protected at all banks. The FDIC proposed some interesting options along those lines in a report last year. Of course, the benefits of a higher limit have to be weighed against potential costs, such as whether deposit insurance premiums would need to rise or whether a higher limit could increase moral hazard and encourage banks to take excessive risks."
Finally, she adds, "Lastly, I'd note the growing use of reciprocal deposit networks, which allow banks to swap deposits in excess of the limit with each other to provide depositors more insurance. Reciprocal deposits reached $379 billion in the first quarter of this year, up from $157 billion at the end of 2022. The vast majority of reciprocal deposits -- 89 percent -- are at banks with less than $100 billion in assets. That reflects both the funding environment for smaller banks and the less-favorable regulatory treatment of very large reciprocal deposits. Reciprocal deposits can cost banks more than 10 basis points in network fees. Smaller banks' willingness to pay this cost to work around the deposit insurance limit suggests the limit's too low. As a society, if we're going to provide the insurance anyway -- which is what happens when banks use reciprocal deposits -- we may as well increase the limit so we can avoid the costs, operational risks and regulatory mirages involved in passing deposits back and forth between banks."
