From the University of Chicago, Booth School of Business' Stigler Center, ProMarket, December 7:
Due to a change in how the FDIC resolves failed banks, uninsured deposits have become de facto insured. Not only is this dangerous for risk in the banking system, it is not what Congress intends the FDIC to do, writes Michael Ohlrogge.
The recent failures of Silicon Valley Bank and First Republic have drawn attention to how rare it is for uninsured depositors at a failed bank to bear losses. Over the past 15 years, uninsured depositors have experienced losses in only 6% of United States bank failures. In a newly released paper, I show that ubiquitous rescues of uninsured depositors represent a recent phenomenon dating only to 2008: for many years prior to that, uninsured depositor losses were the norm. I also show that the rise of uninsured depositor rescues has coincided with a dramatic increase in Federal Deposit Insurance Corporation costs of resolving failed banks, which I estimate resulted in at least $45 billion in additional resolution expenses over the past 15 years.
The growth of uninsured depositor rescues raises serious concerns about moral hazard as well as fiscal costs. It also risks violating the FDIC’s statutory requirement to resolve failed banks and protect insured depositors in the least expensive way possible. I present evidence that the best explanation for the growth of uninsured depositor rescues is that the FDIC has experienced “mission creep,” resulting in the rescue of uninsured depositors far more frequently than Congress intended. This mission-creep occurred twice in the past, and Congress successfully intervened to stop it in 1951 and 1991. It may now be time for a third such intervention from Congress.The Least-Cost Resolution Requirement and the Systemic Risk Exception
Current law requires the FDIC to resolve failed banks in the least expensive way while still protecting insured depositors. As a reminder, the law stipulates that deposits up to $250,000 held at any FDIC-insured bank are backed by the federal government. Sometimes, rescuing uninsured depositors may in fact be the cheapest way to protect insured depositors. For instance, suppose the failed bank will be purchased by another bank who will continue to operate it. The purchaser might prefer to keep customers of the failed bank happy by honoring even uninsured deposits, and thus might pay more for the failed bank’s assets if uninsured depositors are made whole. If the extra amount the acquirer will pay for the failed bank’s assets is greater than the cost of reimbursing uninsured depositors, then it will be cost-effective to fully compensate even uninsured depositors.
Frequently, however, uninsured depositor rescues increase the total resolution costs. If the FDIC believes it is necessary to rescue uninsured depositors, despite it not being the lowest cost option, then it must invoke the “Systemic Risk Exception.” This requires authorization from two thirds of the FDIC Board, two thirds of the Fed Board, the Treasury Secretary, and the U.S. president. The FDIC has invoked this only twice for failed banks: SVB and Signature, both of which failed in 2023. Thus, the systemic risk exception is not invoked lightly. In this paper, I argue that the FDIC has rescued uninsured depositors at hundreds of failed banks in situations where doing so is not least cost, yet without going through the Congressionally mandated procedures for invoking the Systemic Risk Exception.Reasons to Worry About Excessive Uninsured Depositor Rescues...
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