The recent demise of Silicon Valley Bank and a few other regional lenders is forcing policymakers to revisit a difficult question: What should the government do to prevent such damaging bank runs? Should it yet again expand deposit insurance?
There’s a better way.
The SVB debacle illustrated three key weaknesses of modern-day banking. First, in an era of online transactions and social media, runs can happen with unprecedented speed. Second, uninsured depositors aren’t a reliable source of market discipline: They have just two modes, complete inattention or total panic. Third, authorities lack adequate tools to prevent panic. The “systemic risk exception” they used to rescue SVB’s uninsured depositors can be invoked only after a bank has failed and only on a case-by-case basis so as to offer limited comfort to depositors in other institutions.
To address these shortcomings, some politicians and policymakers want to raise the federal deposit insurance limit from the current $250,000 per account—or even remove it entirely. But this would create its own problems. For one, it would cover all institutions no matter how they were managed, and thus would encourage lenders to take even greater risks—as the savings-and-loan crisis of the 1980s demonstrated. Second, it would require a large increase in banks’ contributions to the deposit insurance fund, effectively forcing conservatively run institutions to subsidize their more aggressive counterparts.
What’s needed is a backstop that creates the proper incentives for banks to manage risk. With this in mind, I would propose an expansion of the Federal Reserve’s lender-of-last-resort function (along the lines of a mechanism proposed by Mervyn King, who headed the Bank of England during the 2008 financial crisis). Instead of offering a blanket guarantee, the Fed would promise to lend banks the money needed to pay all their uninsured depositors—but, in exchange, banks would have to pledge sufficient collateral to cover those deposits. Higher-quality collateral would get more credit: The central bank might agree to lend $99 against $100 in short-term Treasury bills, but only $50 against $100 in risky, longer-term corporate loans. With such a backstop in place, uninsured depositors would no longer have an incentive to run, because they would know that their bank would always be able to obtain sufficient cash to honor their withdrawal requests.
Well-capitalized banks with ample high-quality assets would have no problem meeting the Fed’s collateral requirements. By contrast, risker banks with a lot of uninsured depositors would have more difficulty, and would face powerful incentives to change how they operated. Silicon Valley Bank, for example, would have run out of collateral to cover its uninsured deposits long before the panic started. To get back into compliance, it would have had to raise capital, increase its share of insured deposits or reduce the riskiness of its assets—all steps that could have prevented the bank run from happening in the first place.
True, such a mechanism could expose the Fed to losses if a bank failed. But the central bank could minimize this risk by being careful in deciding how much to lend against various types of collateral—that is, by setting conservative “haircuts.” More broadly, it would also likely want to set a margin of error—say, by requiring that total pledged collateral exceed runnable assets by 10%, to which banks would probably add another 5% to ensure they didn’t fall below the threshold.
The Fed’s track record here is reassuring. Its haircuts for both traditional discount window loans and emergency lending have always been conservative. The Fed earned a profit on all its extraordinary interventions from the 2008 financial crisis, including loans made against the risky, illiquid collateral of investment bank Bear Stearns and insurer AIG.
When things go wrong, policymakers must evaluate whether incentives are well aligned with the outcomes they seek. If not, the incentives need to be changed. Backing deposits in a way that encourages banks to act responsibly would be an excellent place to start.
Bill Dudley, a Bloomberg Opinion columnist and senior advisor to Bloomberg Economics, is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief US economist at Goldman Sachs. He has been a nonexecutive director at Swiss bank UBS since 2019.
This article was provided by Bloomberg News.