Uninsured depositors are a threat to the U.S. banking system.

Uninsured depositors are a threat to the U.S. banking system.


The Importance of Deposit Insurance in the US Banking System

Deposit insurance plays a critical role in ensuring stability and confidence in the US banking system. In the United States, deposit insurance is provided by the Federal Deposit Insurance Corporation (FDIC) for banks and the National Credit Union Administration for credit unions. While the current maximum amount covered is $250,000 per depositor, there is a growing concern about the increasing level of uninsured deposits in the banking system.

The Rise of Uninsured Deposits

Uninsured deposits now constitute around 40% of all deposits, a significant increase from 20% three decades ago. This rise in uninsured deposits presents a lurking problem for banking stability, particularly in the era of online banking. Depositors who are not covered by deposit insurance are often slow to recognize financial problems within their banks. However, when they do realize the situation, their reactions are swift and massive, leading to large-scale withdrawals. These withdrawals can trigger similar actions among depositors at other banks, leading to highly disruptive consequences for the US economy, including contagion risks.

Extending Deposit Insurance Coverage

To address this instability, one solution is to extend deposit insurance to all deposits and depositors, regardless of the amount. This would require Congressional action to amend the current statutes governing deposit insurance. Additionally, the FDIC would need to increase deposit insurance premiums and adopt a risk-adjusted approach to ensure the long-term sustainability of the insurance program. Adjusting the maximum insured deposit amount for inflation alone would call for an increase to $350,000, considering the 40% increase in the consumer price index since 2008.

Furthermore, expanding deposit insurance coverage would provide an opportunity for increased transparency in bank regulation. Currently, regulators are often secretive due to fears that revealing bad news could trigger destructive bank runs. However, with all depositors insured, this risk would no longer be a factor, allowing for more open and transparent bank regulation.

Addressing Moral Hazard and Enhancing Monitoring

One concern often raised against expanding deposit insurance coverage is the potential increase in moral hazard. Critics argue that banks may engage in riskier behaviors because large uninsured depositors would no longer have incentives to monitor the banks. However, the existing experience with large uninsured depositors reveals that they only become concerned at the last minute. Depositors, insured or uninsured, are generally not effective monitors of bank managers.

One alternative approach to address this issue is to require banks to issue subordinated debt. These bondholders would hold longer-term debt, limiting their ability to withdraw funds and making them more sophisticated and knowledgeable about banks and banking compared to depositors. To incentivize vigilant monitoring, these bondholders should be given governance rights, allowing them to oversee senior bank managers and exercise necessary restraints.

Reviving the Discussion on Subordinated Debt

The idea of mandatory subordinated debt was widely discussed after the financial crisis of 2007-2009 but lost traction over time. Currently, the US banking system only has $65 billion in subordinated debt outstanding, a mere 0.3% of total assets. Given the current situation and the potential risks ahead, it is crucial to revive this discussion and consider implementing measures to increase the issuance of subordinated debt.

Addressing Concerns of Subsidization

Opponents of expanding deposit insurance often argue that the beneficiaries would primarily be high-income households, which could result in subsidy from the general public. While this concern is valid, it is essential to acknowledge the inherent instability costs that uninsured deposits create for the banking system. The potential negative consequences of large deposit withdrawals on other depositors should be taken into account.

Exploring Alternatives

If expanding deposit insurance seems unfeasible, there are other measures that can reduce the flighty nature of uninsured deposits. The guiding principle should be to recognize the negative externalities associated with large deposit withdrawals, similar to pollution or congestion. These measures would aim to slow down or make the withdrawals of uninsured deposits more costly. Several proposals have recently emerged, and consideration should be given to their impact and effectiveness.

The Need for Timely Action

While recent bank runs have not escalated and the system appears stable, the underlying issue of the flighty nature of uninsured deposits and the inherent fragility of the US banking system remains. The upcoming challenges, such as the potential downturn in the commercial real estate market, may further stress the system. As the saying goes, “The best time to fix the roof is when the sun is shining.” It is crucial to address these concerns promptly and proactively to ensure the long-term stability of the US banking system.

Lawrence J. White is a professor of economics at the NYU Stern School of Business and a former federal regulator of the savings and loan industry from 1986 to 1989.

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