Which American bank is the next domino? The question now no longer seems to be whether panic will arise again in the United States about a small regional bank, but which bank that will be.
The week started with the rescue of First Republic by JP Morgan, the largest US bank. That calmed the financial markets somewhat, but soon another victim was found: PacWest. After the news that that bank was looking for “strategic options” and financing partners, the share plummeted. Other regional banks also saw their prices collapse.
The ongoing panic is now raising the question in the US of whether the current means to support the banking system, which is so important to the economy, are still working. The discussion focuses mainly on the deposit guarantee scheme that now guarantees deposits of up to USD 250,000 in the US (in Europe the guarantee runs up to EUR 100,000). Does the way it is now organized cause additional panic among account holders and investors?
A deposit guarantee scheme is precisely intended to prevent bank runs. If a bank fails, account holders can always access their money. The idea is that if there is negative news about their financial institution, account holders will not immediately pack their bags and withdraw all their money.
In the US, a domino of bank runs in the 1930s was the reason why a national deposit guarantee system was set up there. With the establishment of the Federal Deposit Insurance Corporation (FDIC) in 1934, which guaranteed savings amounts of up to $ 2,500, peace was indeed restored to the American banking sector. In 1934 only nine banks went bankrupt, compared to nine thousand in the previous four years.
Size three bank balance sheets
In 2023, it is no longer about thousands of bankrupt banks – the FDIC covers a total of just over four thousand banks. But the fall of Silicon Valley Bank (SVB), Signature and First Republic in recent months has had a major impact. The balance sheets of the three banks together are slightly larger than all the US banks that failed during the credit crisis that were covered by the FDIC guarantee scheme (as investment banks, Lehman Brothers and Bear Stearns were not included).
The pain is in the limit in the deposit guarantee system: deposits above USD 250,000 are no longer guaranteed. This does not mean that the assets above that are gone in the event of an uncontrolled bankruptcy of a bank. However, there is a good chance that account holders will not be able to access their money for a long time: only after the bankruptcy has been settled and the assets have been sold. And whether the full amount will be returned is also the question.
The guarantee limit played a major role at SVB, Signature and First Republic. Many of their customers had more than $250,000 in their account. As soon as it became known among those account holders that their bank was having financial problems, they emptied their account en masse. For example, First Republic clients withdrew $100 billion from the bank in the first quarter, more than half.
In doing so, the customers aggravated the financial problems of their (former) bank even more. In order to have sufficient liquid assets to pay out the savings, the banks had to sell loans and other assets at a loss. One of the causes of SVB’s fall was the announcement of a $1.8 billion loss on the foreclosure of US Treasury bonds that were on the books for $21 billion.
After the bankruptcy of SVB – due to the emptying of savings accounts, the FDIC had to intervene – peace only returned to the financial markets after that bank’s assets in excess of USD 250,000 were also guaranteed. Shortly afterwards, Treasury Secretary Janet Yellen hinted that he wanted to do the same for other stressed banks, but that was only a short-lived reassurance for the financial markets. With PacWest reeling and gossip surrounding the Western Alliance about a “strategic options” study – which has since been denied by the bank – criticism of the current system is mounting.
The prominent hedge fund manager Bill Ackman tweeted that the US regional banking system “is in danger”. Banking is a trust game. At this rate, no regional bank will survive bad news or bad numbers, as a share price inevitably follows and insured and uninsured assets are withdrawn.” According to Ackman, the FDIC must make a final commitment that all assets above $ 250,000 will be guaranteed. “The failure to deliver on that promise has driven more nails into First Republic’s coffin.”
The FDIC published last Monday – coincidentally just before the announcement of the rescue of First Republic – a study into possible alternatives to the current system. The conclusion was that an increase in business credits would be a good idea, so that companies can always transfer their salaries and pay suppliers. The FDIC did not disclose an exact amount, but the media say it is thought to be $ 2.5 million. For private individuals, the limit would remain at a quarter of a million. However, it will take some time before a new system comes into effect – according to Ackman, the FDIC should therefore already issue a hard guarantee in the meantime.
Insurance reimbursement advocated
The activist investor Nelson Peltz made an additional proposal in the Financial Times this week. Account holders with more than $250,000 in their account would be required to pay a small insurance fee to the FDIC in exchange for a guarantee. That should stop the bank run on regional banks. “We are one of the few countries where there is a large network of small regional banks. They have supported small businesses for over a hundred years – I don’t think we can afford to lose them.”
According to Harald Benink, professor of banking and finance at Tilburg University, one should not only look at increasing the deposit guarantee scheme. According to him, the way in which the system is now organized is “no longer credible”, especially given the speed at which customers can withdraw their money via their smartphone and the speed at which news and gossip about financial institutions can spread on social media.
Read also: What happened to ‘no more banking crisis’?
The idea of a limit to the ‘insurance’ offered by this system was precisely intended to moral hazard that such a system causes, the FIDC also writes in its research. After all, the danger of a guarantee is that bank managers, because the money they manage at their bank is ‘safe’ for the account holders, will take more risks in their lending and investments. After all, there is no incentive whatsoever for consumers and businesses to find out which bank is financially healthy and which is risky with the savings entrusted to it.
Let the bank park payment balances at the central bank
Harald Benink professor
By setting a limit, there should still be some incentive for customers to look for a safer bank and thus encourage banks not to take too much risk in order to attract more savings. By guaranteeing all amounts, that incentive disappears.
However, according to Benink, practice in the US already shows that an implicit guarantee applies above USD 250,000. “That is not surprising, because being able to make payments as a company is an essential function of the economy, a public good.”
According to Benink, consideration should therefore now be given to alternatives that do have a disciplining effect on banks. “For example, ensure that companies and consumers can pay securely by obliging banks to park all payment balances at a central bank in the long term. Banks then have to look for financing for their loans other than the money in the checking accounts. That can really have a disciplining effect, because banks then have to convince their bondholders and shareholders that they are not a risky investment.”
A version of this article also appeared in the May 6, 2023 issue of the newspaper.