On October 18, 2024, regulators closed First National Bank of Lindsay (FNBL), OK. In a departure from other recent bank closures, the FDIC elected not to fully reimburse uninsured depositors. What does this decision say about moral hazard, market discipline, and which depositors the government chooses to protect?
Moral Hazard and Deposit Insurance
Regulators took the action “after identifying false and deceptive bank records and other information suggesting fraud” that depleted the bank’s capital. FNBL had total assets of $114 million. Uninsured deposits totaled about $14 million. Depositors will receive the fully insured portion of their deposits and at least half of the remaining portion. They may receive more depending on recoveries. The average partially insured depositor had a balance of $554,000 and stands to lose about $152,000. (I’m using June 2024 Call Report data. The reported levels as a September are obviously wrong, with “accounts more than $250,000” averaging only $234,000.)
The depositor profile of FNBL stands in stark contrast to that of Silicon Valley Bank. Uninsured deposits represented 94% of SVB’s total deposits. These large deposits had an average balance of $4.18 million, or about 7.5 times that of the average FNBL depositor. And some of the deposits at SVB were really large. Excluding affiliated entities, these firms had the largest deposit balances at SVB:
In each case shown above, the FDIC wound up fully insuring deposits more than one thousand times the legal limit. Take the case of Circle Financial, a stablecoin firm with $3.34 billion in deposits at SVB. It’s like insuring your diamond ring for only $1 but asking your insurance company to pay out more than $13,000 after you lose it in the sink. Good luck with that.
The rescued depositors have been described as “small businesses across the country that banked there and need to make payroll, pay their bills, and stay open for business.” I don’t doubt some fit that profile. But they also included some large, supposedly sophisticated firms that should have known better.
Covering uninsured depositors is a classic case of moral hazard. The term doesn’t have much to do with morality but instead means there’s little financial incentive to guard against risk when you don’t have to bear its consequences. This can happen with any type of insurance or other financial safety net. The FDIC decided to crack down on moral hazard at FNBL, even though the average large depositor had a balance just over twice the FDIC limit. Regulators looked the other way at SVB, even for deposits one thousand times the FDIC threshold.
How About Market Discipline?
A related concept is “market discipline,” the idea that market participants can monitor a bank’s risks and take action to limit excessive risk taking. Market discipline requires skin in the game by the market participants and access to enough information to make informed decisions. Skin in the game seemed to apply if you had $500K at FNBL but not if you had hundreds of millions at SVB. What about the information side?
As I’ve noted in a previous post, weaknesses at SVB that seem obvious in retrospect, were much less clear in real time. SVB met its regulatory capital requirements and was profitable. Just a month before its collapse, Forbes listed SVB as one of the best banks in the country. The magnitude of the bank run, by far the worst in history, qualifies as a black swan. At the same time, though, there were some clear red flags based on publicly available information. There was extreme concentration in deposits, with more than 90% above the $250,000 FDIC limit. The bank’s investment portfolio was $15 billion underwater, sufficient to wipe out the bank’s capital. You would also expect that firms like Circle, Sequoia, and Roku to have the resources to do a thorough review of SVB.
How about FNBL? Frankly, there was not a lot to go on. As of June 2024 (the most recent Call Report before the bank’s collapse), the bank’s leverage ratio was 9.48%, well above regulatory minimums and more than 100 basis points higher than that of JP Morgan Chase. The bank earned a respectable 1.28% return on assets. Past-due and nonaccrual loans represented 2.11% of total loans and 1.45% of total assets, not great but not especially alarming. Unrealized losses on investment securities represented only 3.42% of capital. There were no outstanding public enforcement actions. Regulators have already concluded the bank’s records were “false and deceptive,” so public financial metrics were likely of little value anyway.
Systemic Risk
FNBL was no one’s idea of a systemically important bank. Regulators decided to cover all depositors at SVB and Signature due to their perceived systemic risk. However, regulators never saw fit to designate these banks as systemically important prior to their collapse. Regulators also have not added any new banks to the ranks of the systemically important since the SVB failure, though the Basel Endgame proposal made some implicit assumptions in that regard.
The collapse of SVB came in a matter of a few days. What data did the regulators have at their disposal? Regulators could identify banks with large concentrations of uninsured deposits from Call Report data. Information on daily or even weekly deposit outflows across the financial system would be a lot spottier. Examiners collect daily deposit data at the very largest banks, but not necessarily at the next tier, which were those most at risk. Some ad hoc reporting may occur. For example, we would get daily or weekly updates from banks on deposit trends during the height of COVID. But remember that SVB collapsed in roughly 48 hours, hardly enough time to set up even ad hoc deposit reporting. And that’s across three federal regulators.
The decision to fully cover SVB and Signature depositors was made at a very senior level: likely Secretary Yellen, Fed Chairman Powell, and FDIC Chairman Gruenberg. I don’t doubt these are bright individuals, but also far removed for day-to-day supervision. It’s unlikely there was much rigorous analysis behind the decision. More likely, the decision amounted to an educated guess by three sleep-deprived septuagenarians.
No doubt regulators were concerned about a possible contagion. Along with fully covering uninsured depositors, the Fed also initiated the Bank Term Funding Program, which offered participating banks liquidity at terms much more favorable than those available in private markets. One immediate beneficiary was First Republic, which had a high concentration of uninsured deposits and was experiencing significant outflows. These efforts allowed First Republic to survive an additional 52 days. Perhaps this gave the FDIC additional time to strike a better deal for First Republic. But when the bank was sold, the FDIC received a premium on First Republic’s deposits of …. zero.
It’s always tricky to deal with counterfactuals. We don’t know whether letting SVB’s depositors absorb some of the losses would have roiled financial markets and brought down a bunch of other banks. I doubt whether the regulators making the decision knew for sure, either.
Reducing Cost to the FDIC
The decision to require FNBL’s depositors to share the losses clearly saved the FDIC money. Along with only paying out uninsured depositors at 50 cents on the dollar, the FDIC received a premium of 6.67% on the remaining deposits. That’s well above the premium received for any of the other 28 failed banks over the past ten years. (The average premium was 0.88%.)
But how much money are we talking about here? The FDIC saved about $7 million directly by not paying out uninsured depositors. The deposit premium on the insured deposits brought in another $5.6 million, for a grand total of $12.6 million.
Now let’s compare those amounts to outlays on SVB, Signature, and First Republic. Concentrations of uninsured deposits at those banks were so high that limiting payouts to insured deposits would likely have led to cost-free resolutions. The table below shows the actual costs to the FDIC of these three large bank failures to total $38.8 billion. Put another way, the FDIC spent $38.8 billion to rescue large depositors at large banks. That’s more than 3,000 times as much as the FDIC saved by making FNBL’s depositors take a hit. It wouldn’t be the first time policymakers failed to see the big picture.
Concluding Thoughts
Regulators’ approach to uninsured deposits at SVB and FNBL may be inequitable but not necessarily illogical. A $38.8 billion resolution cost is a lot of money, but that amount was at least manageable enough to be covered by an FDIC special assessment rather than by taxpayer funds. We don’t know whether standing firm against moral hazard would have spooked financial markets, but it’s easy to see where regulators wouldn’t want another Lehman on their hands. The decision on FNBL will make it harder than ever for small banks to attract larger depositors, but it probably doesn’t make much sense for a $100 million bank to compete in that space. And FDIC’s generosity with SVB’s depositors doesn’t oblige them to repeat that mistake with FNBL.
Shortly after SVB’s collapse, Sen. James Lankford (R-OK) asked Janet Yellen an eerily prescient question: “Will the deposits in every community bank in Oklahoma, regardless of their size, be fully insured now? Will they get the same treatment that SVB just got, or Signature Bank just got?” We pretty much know the answer.