As you may know, I’ve long advocated the abolition of federal deposit insurance. I believe that a free market would provide people with safe places to store wealth, such as narrow banks and MMMFs that invest in T-bills. But my proposal is not politically feasible, at least for the foreseeable future.
Josh Hendrickson has a post entitled:
How Can We Align the Interests of Bank Shareholders with Depositors?
It addresses moral hazard in a way that seems more politically feasible than abolishing FDIC:
This raises a natural question. If shareholders prefer more volatile assets and depositors prefer less volatile assets, how can the preferences of depositors and shareholders be aligned to avoid the insolvency risk just described?
Historically, shareholders of banks were subject to multiple liability. The most common version of this seems to have been double liability. The way that this worked is that a shareholder would buy X dollars worth of stock in the bank. If the bank become insolvent, not only did the shareholder lose his X dollars, but the shareholder was also responsible for compensating depositors using up to X additional dollars of the shareholder’s own personal wealth. This is referred to as double liability since a shareholder investing X dollars in the bank would have a maximum loss of 2X dollars.
It is easy to see how this sort of arrangement would help to navigate the conflicting visions of depositors and shareholders with regards to what banks should do. Multiple liability aligns the financial incentives of the shareholders with those of the depositors by making shareholders responsible for depositor losses.
I like that idea. I’m no expert on banking, but what about simply requiring people (and institutions) that purchase bank stock to make and hold deposits in the bank that are equal to the size of their equity purchase. If you buy $1 million in Republic Bank stock, you must also deposit $1 million into Republic Bank and hold it there until you sell your stock. In that case, the FDIC could continue insuring ordinary deposits, but these special deposits of bank shareholders would be uninsured. (Shareholders could hold other insured deposits, apart for these uninsured accounts.)
From the shareholder perspective, this would double the cost of a bank failure, and reduce the incentive to take excessive risks. It’s also an approach that utilizes market forces. When it comes to regulation, bureaucrats will never be able to anticipate all of the different ways that a bank might screw up. In this proposal, the market is automatically moving banks closer to alignment with uninsured depositors.
PS. This picture shows the FDIC headquarters. Ironically, my old employer (Mercatus Center) is right next door.)
READER COMMENTS
Daniel Carroll
Mar 30 2023 at 10:03pm
Shareholders would need to be compensated for the extra risk they are taking on. There is also the agency cost question – shareholders don’t really control management, and it is management that gets the outsized returns from taking a little extra risk. Indeed it is the higher risk of insolvency due to management errors that probably explains the lower P/E afforded bank stocks.
Michael Sandifer
Mar 30 2023 at 11:37pm
Deposit insurance and implicit deposit guarantees already make boost the prices of bank stocks, to the degree they incent riskier, but more profitable behavior. So, one is taking away a shareholder subsidy. That said, this approach may more than offset the moral hazard.
nobody.really
Mar 31 2023 at 5:47pm
I had a similar reaction. I like the creative thinking (although, to the uninitiated, all thoughts seem like original thoughts.) But is there any support for making an investor’s liability equal 2x the amount invested–and not, say 1.5x, or 3x, or any other number>1? I sense the author picks 2x simply because is tracks a common law practice.
Scott Sumner
Mar 31 2023 at 1:52am
“and it is management that gets the outsized returns from taking a little extra risk.”
Why wouldn’t shareholders benefit from outsized returns?
tpeach
Mar 31 2023 at 2:12am
I don’t think this addresses the issue of “implicit” deposit insurance. Even uninsured depositors of SVB are getting bailed out, and in 2008 countries quickly changed the rules to guarantee all deposits, even countries with no explicit deposit insurance.
Like with monetary policy expectations, if the commitment to NOT bail out uninsured depositors isn’t seen as credible, then moral hazard will still be a problem, even without explicit deposit insurance.
The government can change the rules whenever it wants and politicians are incentivised by the electoral cycle. Politically, the rational short term strategy would be to bail out depositors when any bank fails.
Scott Sumner
Mar 31 2023 at 10:37am
The law could be written in such a way as to not allow bailouts of shareholder deposits. Bondholders are not being bailed out at SVB, and shareholder deposits would be quite similar in a political sense.
Also, there’d be no risk of contagion, as shareholders would not be allowed to flee the bank without selling their stock (and thus transferring the deposit to someone else.)
vince
Mar 31 2023 at 4:09pm
“Bondholders are not being bailed out at SVB”
Yes, they are. SVB had enough assets to pay depositors.
Scott Sumner
Mar 31 2023 at 11:35pm
Do you have a link? I read that FDIC expected multi-billion dollar losses. Has that changed?
vince
Apr 1 2023 at 1:45pm
The most recent SVB financial reports are 12/31/22. SVB reported $14 billion in cash, $102 billion in agency securities at market value, and $74 billion in loan assets–after allowance for credit losses. That amounts to $190 billion in assets, compared to total deposit liabilities of $174 billion. That provides a cushion of $16 billion.
That was 12/31. The FDIC announced last week that SVB on March 10 had $167 billion in assets and $119 billion in deposit liabilities. They sold $72 billion in SVB loan assets to First Citizens for $56 billion (and then First Citizens stock shot up 50 percent). That leaves $63 billion of deposit liabilities. FDIC retained $90 billion in securities, for a $27 billion surplus.
FDIC wasn’t clear whether those $90 billion in securities were reported at par or at market value. SVB had HTM securities on 12/31/22 at par $91 billion and market value $76 billion–the unrealized loss was $15 billion. Duration was about 5.7, but interest rates didn’t move much between 12/31 and 3/10. If you apply the entire $15 billion unrealized loss at 12/31 to the remaining securities held at 3/10, the securities at 3/10 are worth $75 billion on par $90 billion.
The bottom line then is $119 billion in deposit liabilities and $131 billion in liquid assets.
Why doesn’t the FDIC provide full details about this deal, including the entire contract? Whose interests are FDIC serving?
Arqiduka
Mar 31 2023 at 6:27am
OK, just wait a minute. Isn’t the deal such that we insure some (all?) of tou deposits and you agree to be subjected to a rather onerous regulatory framework, with tiers of capital and God knows what else?
Hence, if the insurance bit has been strengthened de facto, it stands to reason that the regulatory bit would be as well, curtaining which assets count toward capital etc.
Where is this “let’s destroy the limited liability form” idea comes from?
Scott Sumner
Mar 31 2023 at 10:39am
“Where is this “let’s destroy the limited liability form” idea comes from?”
Moral hazard.
Arqiduka
Mar 31 2023 at 7:20pm
That’s what regulation is for. Is this a Vader moment, where the banks are supposed to pray we don’t alter the deal any further?
Scott Sumner
Mar 31 2023 at 11:20pm
We’ve tried regulation for 200 years. How’s it working out?
Time to try the Canadian approach?
Arqiduka
Apr 2 2023 at 12:24am
Let’s try to see this from the PoV of the Banks in toto: “we” made them a deal, by which depositors gain often and owners rarely.
We placed onerous restrictions on their ability to generate alpha to balance risk, and now we break the deal since, turns out, the goal was not to prevent calamitous falls in circulation, but to have no bank fail, ever.
Ok, bit of a shonky deal but, hey, we have the guns, and they don’t. Rescind regulation then, since it’s allegedly not working. Let them invest in crypto or whatever, and be jointly and fully liable.
We’re now just one revolution of the Rubik cube from having the Fed just eat them all.
Scott Sumner
Apr 2 2023 at 10:12am
Not sure what you are getting at . . .
Arqiduka
Apr 3 2023 at 1:56am
Sorry about meandering. I mean that the issue of moral hazard due to depositor choice was allegedly balanced by regulation of permissible investments.
If this is thought not to work anymore, abolish/amend limited liability but also remove obstacles to profitable and risky investment.
Maybe even have two tiers of banks, one over-regulated and the other free to invest but without limited liability.
Todd Ramsey
Mar 31 2023 at 8:56am
What are your thoughts on an arrangement where, as a condition of obtaining FDIC insurance, bank executives’ bonuses were paid out 10 years after being earned, conditional on the bank not needing intervention by the FDIC?
Executives would try to get around this regulation with higher salaries, but those could be similarly capped via regulation.
Scott Sumner
Mar 31 2023 at 10:40am
I don’t know enough to comment. It might work.
Spencer
Mar 31 2023 at 9:52am
FDIC insurance minimizes any free market discipline.
Thomas Hutcheson
Mar 31 2023 at 10:10am
While it is true that regulators cannot prevent all the ways bs La can screw up they can at least prevent them in 2023 from screwing up in the was S&Ls did in the 70s, taking on interest rate mismatch
Vivian Darkbloom
Mar 31 2023 at 11:39am
“If the bank become insolvent, not only did the shareholder lose his X dollars, but the shareholder was also responsible for compensating depositors using up to X additional dollars of the shareholder’s own personal wealth.”
This is entirely unrealistic. What’s the enforcement mechanism for tracking down all those shareholders and making them pay up? The enforcement mechanism would not only be entirely unrealistic, it would be prohibitively expensive. In a lot of cases, shareholders don’t even know that they own shares in a particular bank and, if so, to what extent. If I own an ETF in, such as, the S&P 500, do I know how much I’m at stake in respect of a bank that I may own? In a mutual fund? An IRA, 401(k) or a pension fund? Note that Hendrickson did *not* restrict this proposal to a shareholder who owns shares in a bank and also has a deposit in that same bank. The go-around for that should be obvious and singling out shareholders with deposits is too arbitrary if this is based on shareholder responsibility.
Corporate officers and directors do not have limited liability. They can be held responsible for intentional or negligent torts. In a case such as this one of the best things the FDIC can do is bring a negligence suit against those SVB corporate officers and/or directors who may have been negligent in managing the bank’s risk. That would send a needed reminder to the banking community.
https://clsbluesky.law.columbia.edu/2017/06/05/the-duty-of-care-for-bank-directors-and-officers/
Also, eliminating FDIC insurance, even if it is a wise thing, is a no go politically. Again, I would recomment that a more feasible and realistic solution would be to introduce some sort of insured deductible as a percentage of deposits (say, 75 percent?) up to a limit. Most US voters don’t have anywhere near $250K in deposits in one bank account.
Finally, the HTM accounting rule should be revisited and revised. Presently, it takes too much effort to sort through financial footnotes to uncover a bank’s true interest rate risk profile.
vince
Mar 31 2023 at 4:18pm
“Corporate officers and directors do not have limited liability. They can be held responsible for intentional or negligent torts. ”
Corporate officers are employees. It’s difficult to sue an employee except in rare cases of extreme or gross negligence. Careless negligence isn’t enough.
vince
Mar 31 2023 at 4:22pm
Scott wrote: “If the bank become insolvent, not only did the shareholder lose his X dollars, but the shareholder was also responsible for compensating depositors using up to X additional dollars of the shareholder’s own personal wealth.”
Vivian replied: “This is entirely unrealistic.”
How about ending the limited liability of the corporate or LLC entity types? Probably politically impossible anyway.
Scott Sumner
Mar 31 2023 at 11:18pm
“negligent in managing the bank’s risk.”
This misses the point. If bankers are not taking socially excessive risks then they are not doing their job. The system is set up to encourage excessive risk taking. The fact that a bank failed does not indicate that the managers did anything wrong. The problem is moral hazard, not incompetent bank managers.
If Congress didn’t want banks to take excessive risks, they would have set up a different system.
As far as mutual funds, EFTs, etc., can’t you require those funds to have deposits in banks equal to the stock they purchase?
Dylan
Mar 31 2023 at 12:07pm
I feel like I’m missing something, why would anyone invest in banks under those requirements? Wouldn’t banks have to take on even riskier bets to compensate shareholders for the extra capital that is held and can’t be invested in something else?
nobody.really
Mar 31 2023 at 6:00pm
If your goal is to reduce a shareholder’s enthusiasm for risky investments, this might work. But as Dylan argues, it might not; instead, double indemnity might cause investors to demand higher returns on their nominal investment, because they are in fact making double the investment.
That said, if your goal is to ensure a pot of money to compensate depositors (which I understood was the goal of the double indemnity policy), this might not work. Banks in trouble would be sorely tempted to draw on these shareholder funds. It would make more sense to require these shareholders to deposit the matching funds in a trust fund NOT controlled by the bank—much like a pension fund governed by ERISA.
Scott Sumner
Mar 31 2023 at 11:12pm
Hopefully this would cause many banks to exit the sector, as the US has far too many banks. The remaining banks would price loans (and deposits) at a level where they would earn a competitive profit despite this requirement.
Capt. J Parker
Mar 31 2023 at 2:50pm
Individuals and institutions allocate savings among cash, stocks and bonds. If these allocations were stable bank runs would be rare. Fractional reserve banking gets into trouble when there are sizable shifts in how savings are allocated. In 2007-8 the reallocation was out of mortgage bonds and into cash. An IS-LM analysis says that a big shot run increase in liquidity preference would cause nominal income to fall making it even harder for banks to meet the demand for more liquidity. If the Fed targets nominal income level it is basically committing to create more cash so that the new demand for liquidity is met. So – I submit that NGDPLT is not all that different from telling depositors that they are guaranteed to be able to withdraw their deposits. It’s a blunter tool than deposit insurance is all.
I imagine that one rebuttal here is that if the Fed really did NGDLT there wouldn’t be shocks of the kind that result in systemic adjustment of investment choices; allocations would be stable and bank runs would be rare. (Probably a very good argument for today and SVB’s recent troubles) That argument is OK as far as it goes but even the best NGDP prediction market is going to have a tough time predicting the next pandemic, war or earthquake so shocks will happen and the Fed will need to step in with big infusions of liquidity to keep the path of nominal income on track.
No less moral hazard is created by insuring the fractional reserve banking “system” using Fed monetary policy (cash infusions) than is created by insuring fractional reserve bank depositors using FDIC. If one agrees with this then a constant rate of money supply growth rule a la Friedman is makes more sense if moral hazard is a concern.
Scott Sumner
Mar 31 2023 at 11:10pm
“So – I submit that NGDPLT is not all that different from telling depositors that they are guaranteed to be able to withdraw their deposits.”
This is wrong. NGDPLT does not add any sort of moral hazard to the system, whereas deposit insurance adds a great deal of moral hazard.
steve
Mar 31 2023 at 5:37pm
I think I sort of like Mankiw’s suggestion or something like it. Link the payments for FDIC insurance upon the amount of capital a bank maintains or on the amount of risk with the deposits accounting for size of deposits and concentration of the source of deposits.
Steve
Scott Sumner
Mar 31 2023 at 11:08pm
I still like Josh’s idea better. Things like capital ratios are never able to fully capture the risk a bank has undertaken.
Thomas Hutcheson
Apr 1 2023 at 8:51am
Just be be sure I understand, the problem to be solved by not having deposit insurance is ….?Banks will pass on to depositors (via FDIC premiums) the cost of stockholders allowing management to run risks with positive expected values that nevertheless can wipe them out if things go wrong?
Andrew_FL
Apr 1 2023 at 9:11am
Scotland had Unlimited Liability
Jose Pablo
Apr 2 2023 at 6:41pm
If you buy $1 million in Republic Bank stock, you must also deposit $1 million into Republic Bank and hold it there until you sell your stock.
There is no reason why shareholders themselves should “risk” this “buffer”. They can always find other investors willing to hold this “buffer deposits/capital”. Shareholders will just bear the cost of compensating these other investors for the risk they are willing to take. The higher the risk the more expensive the compensation.
Letting different people buy precisely the risk they want to buy makes the whole system more efficient.
This is, in a nutshell, the idea behind “CoCos”. Looked great in theory but does not seem to have worked that well in practice (as it is frequently the case)
nobody.really
Apr 25 2023 at 10:55am
Peter Coy, NYT
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