A year ago, after the wreckage of the bank failures led by Silicon Valley Bank had been cleared, reforming deposit insurance was offered as a way to reduce the risk of future bank runs

More recently, the effort has been sidelined by the battle over proposed rules to raise bank capital requirements and liquidity. Down but not out, deposit insurance reform is still one of the moves that Congress and regulators may make in coming months. And public funds investors have a particular interest.

But First. . .  

Bank regulators continue to advocate for robust new capital rules to implement the so-called Basel III Endgame. If banks had more capital, they would be better able to deal with bank runs, they argue. Bank pushback has been strong, and the regulators are now hard at work revising their initial proposal.

Meanwhile, a contingent of academics and former Fed officials recently published a paper arguing  that  the way to deal with runs is to beef up liquidity requirements for mid-sized and larger banks. If banks had enough liquidity on hand to meet 30 days of deposit outflows they could fight off a run, they say.

Capital and liquidity requirements would be unpleasant medicine for banks. They would disrupt business models and lead regulators to exert more influence over lending and investing activities.

Enter deposit insurance reform. 

Bank Deposit Insurance Reform Proposals

Deposit insurance reform, on the other hand, is almost a gimmie. Banks would get an affirmation of the essential nature of banking (“your deposit is guaranteed by Uncle Sam”) and expanded deposit insurance could help smaller banks attract and retain deposits at a time when the giants of the industry are on an aggressive growth track. True, expanded insurance would require an increase in the insurance premium banks pay to support the Federal Deposit Insurance Corporation’s (FDIC) program, but this is a small economic hit when compared with the economic effects of capital or liquidity requirements.

The FDIC analyzed  reform options in a report released last May.  They looked at three ideas:

• Raise insurance limits or provide unlimited insurance. Federal deposit insurance currently is limited to $250,00. Government entities ("public units" in FDIC speak) can have up to $500,000 of insurance per bank within a state, $250,000 for all time and savings accounts and $250,000 for demand deposit accounts. For banks located outside of the state the total limit is $250,000. This limit was set in 2008, in response to the near collapse of the financial system triggered by the failure of Lehman Brothers. Prior to that the limit was $100,000 (established in 1980).

The $250,000 limit can be “multiplied” by use of reciprocal deposit placement services. A depositor might be able to deposit $25 million or more with full insurance coverage. For public units, the process is straightforward and permitted in most if not all states, but the record-keeping is cumbersome (and sometimes/often ignored?)  as government accounting may require booking and accounting for hundreds of deposit items separately rather than as a single transaction.

• Targeted insurance. Insurance limits could be increased for some types of accounts. The common need is for transaction or payment accounts where the daily flow of funds may lead to higher balances, and where the timing of payments or receipts can lead to temporary increases in balances, sometimes overnight or over weekends. This problem is exacerbated for public units that are required to secure all deposits even for short times. This too requires books and records activities that can be cumbersome (and sometimes overlooked?).

The Transaction Account Guaranty Program, which was created to respond to the financial crisis of 2008, provided unlimited deposit insurance coverage for transaction accounts that chose to participate. But it  was ended in 2012.  

What Should the Maximum Insurance Amount Be?

Is $250,000 the right number? It is hard to know because if the sole effect of insurance were to eliminate bank runs a very high limit ($25 million?) or no limit might be appropriate, but some lawmakers and regulators worry that high, or unlimited insurance would lead to depositors being  insensitive to  the risk that a bank would fail and thus invest irresponsibly.  Thus, there could be “moral hazard” in setting the limit at a high level.

There is no strong economic analysis to support the $250,000 limit that was established in 2008, or even the $100,000 limit set in 1980. For what it is worth, adjusting the insurance limit for inflation would lead to an increase to $380,000 (based on the 1980 limit of $100,000) or $366,000 (based on the 2008 limit).  Cost of Living adjustments were actually provided for in an insurance reform package enacted in 2005, but they were subsequently overridden by the Dodd Frank Wall Street Reform Act of 2010. 

How Does Security for Public Unit Deposits Impact Reform Proposals?

Perhaps the insurance limit for public units should be raised to reduce or eliminate the need for collateral to secure deposits. Collateralization is the rule for public units, but it is not available to non-governmental entities. There is no uniform national standard; rather a patchwork of individual state laws applies. One aspect of this patchwork is to complicate collateralization by out-of-state banks. And there is no national best practice for public unit investors.

Collateral provisioning has a cost to banks and may limit their flexibility. Positioning collateral for fast action to counter deposit outflows is now on the best practices list for bankers and regulators. But collateral pledged to public deposits is generally segregated and thus not immediately available for other purposes at the bank so that, for example, it would not be available on short notice to support borrowing from the Federal Reserve or FHL Banks to respond to sudden deposit outflows. 

The Bottom Line

Targeted insurance for public units with a significantly higher limit than the current $250,000 would support community banks and could greatly reduce, if not eliminate, the need to collateralize public funds deposits. This could help public units invest in their communities, help community banks compete for public funds deposits, and give all banks greater flexibility in provisioning collateral to provide liquidity for their businesses.

There is precedent for such an approach:  In 1974 when the insured account limit was raised to $40,000 for depositors generally, it was raised to $100,000 for public unit time and savings deposits held by state and political subdivisions. This increase benefited banks by allowing them to better compete for public deposits and by freeing pledged assets associated with public deposit accounts