US regional banking crisis and the need for deposit insurance

Financial markets and the banking system breathed a sigh of relief on May 1st following news that First Republic, the troubled San Francisco-based lender that had hovered on the edge of failure for days, would be acquired by JPMorgan Chase, the nation’s largest bank, with funding and loss-sharing support provided by the Federal Deposit Insurance Corp. (FDIC). The S&P 500 index finished flat on the day, while the Wall Street Journal declared that “Banking Crisis Redux Seen as Unlikely.” First Republic joined the Silicon Valley Bank and Signature Bank collapses last month as three of the largest bank failures in US history, but all three were successfully sold off to other industry players.

But the respite was brief, as shares of several other regional banks that bear some of the characteristics of the recently failed banks came under pressure on May 2nd. Investors are wondering which might be the next bank to topple, while hedge funds who covered short positions in First Republic are moving their exposure to new targets. Shares of PacWest Bancorp (ticker: PACW), for instance, fell 28% on May 2nd and are down 75% since Silicon Valley first began to show signs of stress in early March, while stock of Phoenix-based Western Alliance (ticker: WAL) fell 15% on May 2nd and are down 60% since early March. The KBW Nasdaq Bank Index, which is weighted toward smaller banks, fell 4.5% on May 2nd to trading to a one-year low. As of May 2nd, PacWest shares were trading at 0.35x tangible book value, a level suggesting significant distress and one that makes it nearly impossible to raise primary capital due to the dilution imposed on existing shareholders. Another government-assisted rescue appears likely.

Some might argue that the failing regional banks are getting their just desserts. In each case the banks focused on business customers who held deposits well in excess of the current $250,000 limit to qualify for FDIC insurance. As the Fed has aggressively raised interest rates in recent months to fight high inflation, regional banks have seen their securities portfolio holdings, largely comprised of US Treasury bonds and other low-risk fixed-income instruments, decline in value, while their funding costs have risen, pressuring their capital ratios. This left the banks vulnerable to runs by their customers when concerns emerged about the health of the institutions, with clients holding uninsured deposits the first out the door. Silicon Valley’s and Signature’s deposit bases were 94% and 90% uninsured in the latest reporting periods leading up to their collapse, while First Republic’s was 68%. Now known in banking circles as the “Silicon Valley ratio,” the percentage of uninsured deposits is a key metric investors are using to benchmark regional banks in the current crisis – PacWest reported its uninsured deposits represented 73% of the total as of April 24.

The I-told-you-so crowd has said the banks should have gotten out in front of the Fed’s rate hikes by better hedging their interest-rate risk, and in Silicon Valley’s case should not have concentrated so much of its business in venture-backed companies. Yet the Schadenfreude that has greeted the recent regional bank trouble overlooks the difficult predicament in which the Fed placed these firms through its extraordinary monetary policies in recent years, an environment the less diversified, business-focused regional banks are inherently less equipped to manage than their money-center bank competitors. By leaving interest rates at or near zero for so much of the post-GFC decade, while further suppressing yields on fixed-income instruments through multiple rounds of quantitative easing, the Fed made it nearly impossible for banks to generate decent yields on their assets without abandoning their risk standards. Large banks have not proven necessarily more prescient than their smaller peers in guarding against the interest-rate hikes of recent months: the FDIC’s most recent industry-wide update reported that US banks in aggregate had $620bn in unrealized losses on their securities portfolios as of December 31, 2022 (1Q23 data is not yet available), a not-unsizable figure relative to the industry’s $2.2tr in equity. But the large banks have more diversified business models, cushioning the weakness of the banking businesses. The biggest banks importantly also benefit from lower funding costs in part due to their status as Systemically Important Financial Institutions (SIFIs), a post-GFC designation guaranteeing government support if they near failure given their importance to financial stability.

Regardless of what you think of their managements’ missteps, the vitality and heterogeneity of the U.S. banking system has been lessened by recent bank failures. The U.S. derives great benefit from the fact that we have more than 4,500 banks, in contrast to many other countries that have just a few. Local and regional banks can focus more closely on specific regions and sectors, providing customer service and, lately, fintech innovations tailored to smaller markets. What if a lot more U.S. banks fail and are absorbed by larger peers? A recent poll in Switzerland found that 75% of respondents would support legislation to break up the megabank that is being created from the proposed UBS-Credit Suisse merger.

A report released by the FDIC on May 1st – perhaps overlooked as it was published the same day as the First Republic merger news – offers a path forward. Placing the recent bank failures in the context of the FDIC’s 90-year of history, the agency submits that a refresh of the deposit insurance system is in order in a world where bank runs can happen within minutes, and information (and disinformation) can be transmitted within seconds. In a low-yield world, the cost of deposits relative to debt or other funding sources is more attractive. Thus the FDIC found that uninsured deposit balances grew at a 10% annualized rate from 2009 to 2022. The agency highlights that this trend is not limited to smaller banks. Quite the contrary, “[w]hile many banks have increased their reliance on uninsured deposits, the trend has been most pronounced among the largest banks”, the FDIC said, finding that banks in the top 1% of asset size distribution held 77% of insured deposits in domestic offices.

The agency posits three options for expanding deposit insurance: Limited Coverage in which the current structure is maintained but the current limits raised; Unlimited Coverage in which all deposits are guaranteed; and Targeted Coverage, in which substantial additional insurance coverage could be provided to business accounts, while consumer thresholds remain unchanged. The FDIC comes down squarely on the side of Targeted Coverage expansion as the preferred option. “Extending deposit insurance to business payment accounts may have relatively large financial stability benefits, with fewer costs to moral hazard relative to increasing the limit for all accounts.” To those who might counter that higher business deposit insurance coverage could encourage higher risk-taking, the FDIC notes that the insurance premiums are paid by the banks themselves, providing a natural check on risk.

The FDIC report pointedly does not specify a level at which business deposit insurance should be set, and acknowledges that more details need to be worked out. But the market is clearly calling for further action to support the regional banks to stem the crisis. The FDIC report provides a credible, thoughtful jumping-off point. Even a meaningful discussion in the policy community of higher business deposit insurance thresholds could represent a lifeline to the most challenged regional banks. Some Members of Congress have already called for greater deposit insurance, appreciating the value of regional banks not just as engines of their local economies, but as sources of well-paying jobs and civic pride. At a minimum, FDIC Chairman Martin Gruenberg should be called to the Senate Banking and House Financial Services committees as soon as possible to detail his agency’s timely report (a media report suggest Gruenberg is scheduled to testify on the recent bank failures on May 18th with give other federal and state regulators). Congress, the FDIC and its fellow prudential regulators should dig in into the issue in earnest. Otherwise, more regional banks are likely to fail, with negative effects on lending, the FDIC insurance fund – and a key element of the US banking system’s vibrancy.