Depositors are moving their money away from regional banks in the wake of Silicon Valley Bank’s collapse two weeks ago. Los Angeles-based Pacific Western is the latest to come under pressure.

The fear amongst depositors is palpable—especially amongst businesses that are large enough to have deposits exceeding the FDIC’s $250,000 insurance cap, but too small to have sophisticated treasury operations. 

Brent Frederick, who owns five restaurants in Minneapolis, told the WSJ, “I think we need to analyze banks just like they analyze us…what is the bank’s core value? What do their balance sheets look like?”

It’s hard not to think something has gone terribly wrong here. As Nobel-prize winning economist Joseph Stiglitz recently wrote, “a safe and sound banking system is a sine qua non of a modern economy, and yet America’s is not exactly inspiring confidence.”

How did we get here?

Under current rules, deposits are insured to a limit of $250,000. More than $9 trillion of deposits, or more than 40% of the total, lie above this cap and are uninsured. In a bank failure, these depositors line up with the bank’s other creditors hoping to recoup their uninsured funds as the bank’s assets are liquidated. In other words, they are not protected.

Senator Warren would like to see that $250,000 cap raised. How high? “This is a question we’ve got to work through. Is it $2 million, is it $5 million, is it $10 million?” she asked in a recent TV interview. 

Senator Warren is right. The insurance cap is too low. This may be a rare case of good politics being good policy. But her proposal doesn’t go far enough. The cap should be removed entirely.

Why insure deposits to begin with?

Economic growth is predicated on savers channeling their money to creditworthy enterprises. Some of that happens via the stock market, but a lot of it happens through banks, who package deposits into loans. When savers lose faith in banks, they put the money they need for daily transactions under their mattresses, or in money market funds which invest primarily in short-dated government debt. This cuts the flow of savings to worthy projects. Without credit, the economy comes to a standstill.

If deposit insurance is so beneficial, why cap it at $250,000?

In one line of thinking, depositors act as a check on banks by moving their funds away from those that are taking too much risk. Bank managers are motivated to behave cautiously in order to retain deposits. The corollary is that, if deposit insurance is too generous, the incentive for depositors to monitor bank risk weakens, and bank crises become more likely.

Here is Sheila Bair, former FDIC chair, expounding on this idea:

…I think we need some market discipline to complement the supervisory process. Examiners can't do it all on their own, and the theory is…more financially sophisticated, large depositors can understand a bank's financial condition, can review their deposit base, their loan quality, their asset quality, and make, you know, informed decisions about which banks are safe and reward the banks that are being better managed. 

But many are now questioning this logic. 

The argument for limited depositor insurance rests on the assumption that depositors are able to sniff out banks behaving badly. But this assumption is falsified by what happened at SVB.

The bank was sitting on a powder keg of long-dated, volatile government debt. Regulators didn’t flag this risk. Neither did rating agencies. Moody’s assigned SVB an A1 rating until the moment it collapsed.

If regulators, supervisors, and rating agencies struggle to identify unsound banks before they fail, can we really expect depositors to make that distinction?

Through their behavior, depositors are giving us the answer. Many are spreading their funds across multiple banks to stay below the $250,000 cap, signaling that they can’t tell whether their bank is safe or not. 

Carrots and sticks: who should monitor banks?

This isn’t to say that the private sector can’t help bank regulators and supervisors identify risks before they turn into crises. But investors—bondholders in particular—are far better placed than depositors to do this (shareholders are too focused on profits to be useful here). In a liquidation, because bondholders receive their pound of flesh after depositors, they have more to lose. Bondholders are also rewarded for their good judgment—investors who lend to well-run banks are repaid with interest.

Opponents of higher deposit insurance mistake depositors for investors. Bank savings accounts pay lower interest than US Treasury bills. Half of SVB’s deposits were sitting in non-interest bearing accounts. The reason savers use banks is because they are convenient and safe, not because they are profitable. Depositors are not investors, they are customers.

Even if depositors could monitor bank risk, should they?

Monitoring bank risk has all the elements of a “public good”—it has a positive effect even on those who don’t pay for it. The benefits of keeping tabs on banks accrues not just to the bank doing it, but to “free-riders”: other depositors who may not be doing their due diligence, and to the wider public who benefit from a sound financial system. Since it is impossible to charge these free-riders for the work of monitoring, it’s unreasonable to expect private actors to do it, or at least to do enough of it. Just like monitoring the air and water, monitoring banks is a task for the government.

And there are other clear advantages of the government doing bank monitoring, like economies of scale, and the fact that the government has access to non-public information gleaned through inspections.

Bank runs are a bad way of holding management to account

Another reason depositors shouldn’t be involved in monitoring banks is that, like babies throwing their toys out of the playpen, they don’t have a constructive way of expressing their concerns. 

SVB is a case in point: deposits trickled out at a glacial pace starting in mid 2022, even as the bank was obviously running enormous risk in its portfolio of government bonds (this information was clearly and publicly disclosed in their financial reports). Once concerns crossed a tipping point, depositors fled en masse in the span of three days. Banks don’t break bad overnight, they take excessive risks gradually. The pressure they come under to reign in excessive risk should also mount gradually. 

Moreover, bank runs are not a constructive way of getting management back on the right track. They force banks to sell their assets in a rush, at bargain prices, to meet redemptions. In this way, a solvent but illiquid bank quickly becomes both illiquid and insolvent. Typically, a larger bank swoops in to feed on the smaller bank’s carcass, making huge profits while exacerbating the problem of banks becoming increasingly “too big to fail”. 

Deposit insurance would put an end to these kinds of value-destroying bank runs.

History never repeats itself, but it does often rhyme

Opponents of higher deposit insurance argue that the savings & loan (S&L) crisis in the 1980s and early 90s is proof that deposit insurance leads banks to take excessive risks. But the FDIC’s investigation into the causes of the crisis point in another direction entirely: it “had more to do with inadequate supervision and regulation of S&Ls than with the existence (or even the terms) of the [insurance].”

Deposit insurance did exactly what it says on the label: despite the turmoil, there were no widespread bank runs.

This isn’t to say the system worked perfectly. Taxpayers ultimately lost $132 billion. The S&L insurer went bust. But that same FDIC’s investigation pinned the blame on the way it resolved the failed banks, allowing them to limp slowly and expensively to their deaths. It should have wound them down promptly.

Legislation passed in the wake of the S&L crisis resolved these problems. The FDIC now has to clean up bank failures while minimizing the cost to taxpayers. Even when the FDIC deems a bank failure a systemic risk and winds it down in order to limit spillovers rather than cost, the taxpayer has rarely suffered losses. Banks now pay higher fees into the FDIC’s insurance fund, and the fees are set according to each bank’s risk profile.

The FDIC has never lost as much as it did during the S&L crisis. During the financial crisis the FDIC guaranteed all non interest-bearing transaction accounts across all banks. It suffered just over $2 billion in losses—a rounding error on the $800 billion of deposits it covered.

The biggest loss the FDIC ever suffered winding down a bank was $12 billion on IndyMac, the mortgage lender that failed in 2008. But the cost wasn’t accrued making depositors whole, it was from selling IndyMac for a song to a consortium of investors who didn’t want to take on its sprawling and deficient portfolio of mortgage loans.

American exceptionalism and bank regulation

When SVB set off concerns about the stability of regional banks, depositors fled to the large, “globally systemically important” ones, like JP Morgan Chase and Citibank. This is exactly what insufficient deposit insurance does—it pushes depositors towards the big, systemically risky banks with implicit government guarantees and away from regional and community banks; the main providers of funding to smaller and more rural economies.

At 60%, the proportion of deposits covered by insurance in this country is twice as high as the global median. But in most countries, the banking system is more consolidated. Deposit insurance is less critical because there is nowhere for the money to run to. The US has, by far, the highest number of banks of any country in the world. 

The UK, France, and Germany also have a high number of banks (though still far fewer than the US). But in those countries, regulation is more strict: they apply to all of their banks the same regulation that the US only forces on its largest. Deposit insurance is less critical because the risk of failure is lower.

This raises a final, but important question: should US deposit insurance be increased only after banks come under more strict regulation? The answer must be no—it is in fact the lack of regulation that makes blanket, unlimited deposit insurance necessary now. Regulation in the US remains far too lax and should be tightened. But in the meantime, why should depositors pay the price?

Raising the deposit limit, or abolishing it entirely, will need Congressional approval, or to be coded into law by legislation. This week the Federal Reserve hiked rates by another quarter percent. As interest rates rise and liquidity continues to recede, more institutions will be revealed to be swimming with their pants down. If regulators want to avoid more SVBs, they should implore Congress to insure all deposits immediately.