INSURING THE UNINSURED AT SVB

The FDIC announced on March 13^th that it will fully cover all depositors, insured and uninsured, at the failed Silicon Valley Bank.  SVB is the second largest bank to fail in U.S. history.  The same rules will apply for depositors of the third largest bank failure in history, Signature Bank.

Secretary Yellen and others have indicated that the deposit guarantee doesn’t represent a bailout, noting that the FDIC is only protecting the depositors and not the shareholders.  It really depends on how you define “bailout.”  The government is not keeping the banks open and bailing out shareholders, as was the case in 2008.  The Dodd Frank Act supposedly ended bailouts, at least in the sense of protecting shareholders.  Even the 2008 bailouts usually involved significant dilution of shares at those banks.  Stock prices at the two biggest recipients of the 2008 bailout remain well below their peak pre-crisis levels. 

But the term “bailout” can apply to a wider array of cases.  For example, following the Savings and Loan Crisis of the 1980s, the term “S&L Bailout” shows up 63 times in a word search of the New York Times.  In that case, the government closed the banks and wiped out the shareholders.  Depositors above the then $100,000 insurance limit were only protected if another bank bought the failed thrift.  They were out of luck in the case of a liquidation.  There was a taxpayer rescue of the FSLIC, the insurance fund for S&Ls.  The only ones really bailed out were the still healthy thrifts who would have otherwise needed to pay huge deposit premiums to keep the FSLIC afloat.

Covering uninsured depositors is a classic case of moral hazard.  The term doesn’t have much to do with morality.  Instead, it means that 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, but this case goes a step further.  Let’s suppose you buy car insurance but with a fixed level of coverage, say $20,000.  Now say that you buy a new Maserati MC20 ($217,000 MSRP) and promptly total it.  You can reasonably expect to receive $20,000 but good luck recovering your remaining $197,000 exposure.  Unless your insurer is the FDIC.

Federal law requires the FDIC to resolve failed banks at the lowest cost to the Deposit Insurance Fund.  Since more than 90% of SVB’s deposits were uninsured, limiting insurance coverage to deposits up to $250K would ensure a cheap and probably costless liquidation.  This would also be the case with Signature Bank, where nearly 90% of deposit balances were uninsured.  However, the law also provides for a systemic risk exception (SRE), if pursuing the least costly path would have serious adverse effects on the economy or on financial stability.

The failure of Signature bank just two days after the SVB shutdown indicates that there were clear concerns about contagion.  While SVB and Signature failed, the stock price of First Republic Bank fell from an opening price of $115.25 a share on March 8^th to a low $19.00 by March 13^th, before starting to bounce back.  Roughly 40% of deposits for banks between $250 billion and $700 billion in assets are uninsured.  These banks are not as vulnerable as SVB or Signature but still exposed.  The banking system relies on confidence.  Even a well-capitalized bank leverages ten-to-one and only has enough cash on hand to meet a fraction of its liabilities, many of which are payable on demand.

The trouble with the use of the SRE is that neither SVB nor Signature met the official definition of systemically important.  Prior to the easing of some Dodd Frank provisions in 2018, all banks with consolidated assets exceeding $50 billion were automatically designated as systemically important financial institutions or SIFIs and were required to undergo stress tests, develop resolution plans, and maintain certain levels of liquidity and financial capacity to absorb losses. 

That designation no longer automatically applies for banks with assets of less than $250 billion.  In response to the legislation, the Federal Reserve established a hierarchy in supervising large banks assigning them to Categories I to IV.  The largest and most complex banks (Category I) are considered globally systemically important banks (G-SIBs) and subject to the most intense supervision.  Tailoring removes most of the prior SIFI requirements from Category IV banks, such as SVB and Signature.  In other words, the government decided to cover the uninsured SVB and Signature depositors even though they are above the insurance limit under an exception that is not supposed to apply to them.

Last year, the FDIC and Federal Reserve issued a Notice of Proposed Rulemaking that considers taking additional steps to address financial stability impacts associated with the failure of some other large banks.  The NPR specifically identifies concerns with large uninsured deposits.  However, the rule would apply only to Category II and III banks, which have between $250 billion and $750 billion in assets or meet some other specified risk criteria.  The enhanced supervision would not apply to Category IV banks, like SVB and Signature.

Assumptions about the uninsured depositors at SVB and Signature strike me as a bit premature.  Some described the depositors as “small businesses across the country that banked there and need to make payroll, pay their bills, and stay open for business.”  This sounds a little too much like a Norman Rockwell painting or a Jimmy Stewart film when the average large deposit was about $4 million (about $3 million at Signature).  There is also a legitimate question of whether the supposedly sophisticated venture capitalist depositors even considered insurance limits.

The available evidence doesn’t support the picture of SVB depositors as just a bunch of greedy tech bros either.  Even a relatively small business can have large inflows and outflows of cash.  Large depositors aren’t exclusively businesses or wealthy individuals.  For example, the New York City government had $60 million in accounts at Signature.  Roughly half the deposits at SVB (and more than one-third at Signature) paid zero interest.  The depositors weren’t reaching for yield.  You would expect someone depositing millions of dollars to perform some due diligence.  That didn’t mean they had to be financial experts.  SVB had its share of financial red flags, but earnings, capital, and asset quality ratios looked fine.  In fact, just last month, Forbes listed SVB as one of the best banks in the country. 

A real concern is whether the $250K deposit limit will mean much in the future.  Customers may not take the limit seriously and banks might not either.  It comes down to credibility.  Early in my career, there was a regulation that limited liability growth of thrifts.  Growth above 12.5% over a 6-month period required prior approval ) and submission of a growth plan.  Growth wasn’t always easy to control, and some blew through the limit without approval.  If the growth wasn’t too egregious, we’d send them a nasty letter to the effect that we are very upset and don’t EVER do it again.  Then the thrift would do it again and we’d write a second letter indicating we really mean it this time.  We might escalate to a C&D or other formal action but not always.  I’m not defending this approach, but I understand it. Sometimes it’s a matter of picking your battles and it may not make sense to go to the mattresses every time.  The trouble is that if you don’t follow through on your threats often enough, people won’t take you seriously.

There is a constant tug of war between the prudent and expedient.  Edmund Burke defined society as “a partnership not only between those who are living but between those who are dead and those who are to be born.”  John Maynard Keynes countered that “in the long run, we are all dead.”  There should probably be a balance between the two.  It’s important to stop the bleeding but also to prevent getting cut in the future.

Another major response to the SVB and Signature failures was the announcement of a Bank Term Funding Program by the Federal Reserve.  This program raises many of the same moral hazard issues as paying uninsured depositors and is likely to be even less transparent.  I’ll tackle that issue in an upcoming post.