Although HFSC’s hearing this week is cancelled due to the shut-down, there is no doubt that Congress will give careful consideration to proposals from mid-sized banks seeking a lot more deposit insurance for selected accounts. But this doesn’t mean Congress will also advance this proposal unchanged or unaccompanied. Last week’s letter from Chair Scott to Acting FDIC Chair Hill makes it clear that the Senate Banking Committee head is carefully and correctly thinking through not just which banks win or lose with FDIC-coverage changes, but also what these policies mean to the public good. In short, it’s a lot.
Sen. Scott focuses on three important questions about the second-order effects of coverage change: what might happen to depositor behavior, what rules might need to change to offset unintended consequences, and whether statutory change is needed to limit moral hazard. How FDIC coverage changes for whom drives answers to each of these questions, but several over-arching effects are clear.
First, limiting added FDIC coverage to banks based on certain asset-size thresholds ensures that banks without added protection will not roll over and cough up more insurance premiums. They’ll do what they can to avoid costs unaccompanied by benefit. The largest banks are thus likely to reduce higher-cost domestic deposits and replace them with FHLB advances, wholesale deposits, and global funding. If they substitute these for higher-cost retail and small-business deposits, as seems more than likely, then big banks are also likely to increase their reliance on short-term assets that accord with the significantly-higher duration and liquidity risk presented by this new funding model. So much for small-dollar, short-term loans, credit lines, inventory financing, and lots of other loans customers like and need.
Big banks could also use their competitive clout to remain in the retail-deposit market, reducing returns and/or increasing fees to offset higher FDIC premiums. Either way, the competitive landscape looks even more like a barbell with a few giant banks at one end and dozens or more community banks. Lower-income households, which keep most of their wealth in transaction accounts, will suffer the most and branch banking could shrink because banks that do not depend on consumer deposits need not ensure convenient access to them.
Sen. Scott is also right to ask about moral hazard. Changes to deposit-insurance coverage that do not have these market-distorting and inequality effects are possible, but any increase in federal protection heightens moral hazard unless policy carefully differentiates depositors who can protect themselves from those who need a safety net.
This is a particularly urgent decision because the GENIUS Act counts bank deposits as eligible reserve assets. At one point, the bill limited FDIC coverage in these accounts to the current FDIC-insurance limit. That ceiling is gone in the new law, meaning taxpayers could rescue Circle and other crypto companies again just as they did in 2023. Crypto companies weren’t the only ones in harm’s way during the 2023 crisis, but they can and should have taken far greater care with the billions they housed in heat-seeking deposits at high-risk banks.
The same cannot be said of other depositors. In 2023, many start-up companies also suddenly faced the loss of their payroll funds and virtually every other dollar they had because their funds were entirely held by Silicon Valley Bank. Was this a coincidence? Of course not – SVB conditioned funding to its venture-capital customers by requiring them to invest only in companies that agreed to house all their funds at SVB. I’ve said it before: this is tying and that’s against the law.
FRB supervisors thus should have stopped this and the Fed should have recognized this supervisory failing among the many that precipitated the crisis. The FRB must strengthen its anti-tying rules with express regard to vulnerable depositors and, if it doesn’t, then Congress should make it.
And, finally, we need to be sure that the U.S. is not insuring too much and heightening moral hazard because the FDIC can’t close troubled banks without undue damage to innocent bystanders. FDIC-resolution reform is overdue, as Chair Hill has noted. It should also be linked to FDIC-insurance reform. Most importantly, the FDIC needs to be sure it can do what it’s chartered to do: close failing banks before a crisis precludes options beyond bailouts. The FDIC’s Inspector-General has been clear – the agency still doesn’t know how to resolve a regional bank, let alone a big one.
Congress may need to change aspects of the FDIC’s restrictions in areas such as the least-cost test, but it should first and foremost force the FDIC to prioritize regional-bank resolution to reduce depositor and macroeconomic risk. We don’t know how much of the 2023 crisis was due to the FDIC’s inability to handle SVB, Signature, and First Republic, but it looks like a lot given chaos in areas such as handling double-pledged collateral and obtaining emergency liquidity ahead of closure. The Fed is also at grave fault; talk about discount-window reform is more than two years old without any meaningful improvements.
It may well be that FDIC-coverage triggers should change for high-risk accounts held by vulnerable customers. But, if so, then this needs to be done for all insured depositories in concert with regulatory, supervisory, and resolution safeguards to ensure that taxpayers do not continue to rescue high-risk banks at ultimate cost not only to sound institutions, but also to banking-system integrity and economic equality.