In the aftermath of last year’s bank crisis there were calls to reform federal deposit insurance to add stability to the banking system and diminish the risk of runs on smaller community banks. Deposit reform could also improve the banking environment for state and local governments if they organize around this issue and raise their visibility with regulators and Congress.
While more than a year has passed since the 2023 banking crisis, two recent developments confirm that the opportunity is still very much alive.
Raising the insurance limit on public unit accounts should be in the discussion of ways to stabilize the banking system and level the playing field between large banks and community banks. State and local government deposits are often a core part of the funding for community banks. These deposits currently have added protection vs. other deposits because banks are permitted to collateralize them above insurance limits—protection not available for individual or business accounts.
But collateral requirements are a patchwork, varying from state to state, often difficult and expensive to administer to the point where public agencies may inadvertently fail to meet some arcane requirement. Banks may limit their public funds deposits because of the cost of collateralizing. Raising insurance limits for public agency deposits could reduce the use of collateral, reduce cost and support efforts by community banks to attract and retain these deposits. They should also help community banks pay competitive rates.
The details. Public agencies had $751 billion in bank deposits at the end of the first quarter of 2024, roughly equally split between transaction accounts and time and saving accounts whose primary purpose is investment. That is about $8.3 million per public unit. The figure is skewed by the deposits of the largest state and local governments.
The current insurance limit is $250,000 for all deposits in an out-of-state bank but can be expanded to $500,000 if the depository is in-state, the deposits are in demand deposit and time deposit accounts, and the maximum in either type of account is less than $250,000.
The limit could be raised, for example by increasing the maximum insurable amount to $2 million for all deposits in an insured depository institution or by setting a maximum of $5 million per public unit. We estimate that the $5 million limit could eliminate the need for collateral for all but the 50 states and the largest local governments. States that administer collateral programs on behalf of their local governments (e.g., California, Florida, New Jersey to name a few) would also experience savings because the need for collateral programs would be greatly diminished. Expanding data collected by the FDIC would help make this analysis more precise.
Public agencies address the requirement to secure deposits by limiting deposits in any single bank to $250,000 or by requiring collateral. Both are costly and cumbersome. Spreading deposits among many banks has led to creation of a mini industry of reciprocal deposit services that help a single bank take a large deposit and parcel it out to multiple unrelated banks. But this is not without cost; the services charge 10 basis points or more, paid for by the bank which then passes the cost on to the depositor in the form of a lower interest rate. A higher limit could avoid this cost, and the difference could be used to increase the rate on bank deposits.
Moreover, strict accounting for these deposits requires that the public unit record each separate bank deposit on its books, instead of the lump sum deposit in a single bank. This is so cumbersome that often public units simply book the deposit as a single entry, complying with the spirit if not the letter of accounting requirements.
The alternative, requiring collateral from a bank, has its own costs and complexity. There is no single standard or short form for a collateral agreement; its terms depend on Federal banking law and the laws in both the state where the public unit is situated and the state where the depository is situated. Valuing and monitoring collateral is complex. Thus, best practice may not always be followed, especially by smaller governments.
From the bank’s vantage point collateralizing is also cumbersome and expensive. The rules differ from state to state; only some assets are eligible for collateral and valuation requirements vary. And dedicating collateral to a public funds account limits its availability to support liquidity programs, such as borrowing from the Federal Reserve’s Discount Window.
Targeted insurance coverage could address these issues. Given that public policy already recognizes the need to protect states and local government deposits, why not raise the insurance limit per public unit depositor? This would largely eliminate the need to collateralize. Raising the insurable amount to something like $2 million per bank or $5 million on the aggregate of deposits within a state would add stability, provide support to in-state banks, including importantly community banks, and simplify arranging and keeping records for deposits.
Targeted insurance was an alternative described in the FDIC’s May 2023 report on insurance reform options. We wrote about it in a prior Beyond the News issue. And Fed president Logan’s July speech and the FDIC’s request for comment both address targeted coverage.
Next steps. Altering insurance requires an act of Congress. Various business interests are rallying around the idea of targeting an increase in the limit for business transaction accounts. State and local governments could weigh in with a proposal to raise the limit for public units from its current level. Community banks should be supportive of the target increases as they would reduce their costs and help them compete with the mega-banks for deposits. This would “level the playing field” to steal a bit of Lorie Logan’s thunder.
The FDIC’s request for comments on its data collection effort is an opportunity to raise this issue by encouraging the regulator to collect more detailed information from banks on their public unit deposits that could be used to evaluate alternatives. Among the questions that could be answered: Is $5 million per public unit appropriate? Does the use of public deposits vary significantly by bank size? By bank strength? By location/region? Do public unit investors structure their deposits to meet the $500,000 limit for combined deposits in in-state banks?
This is somewhat unfamiliar territory for public agencies. But with the help of national associations, it should be possible to raise the need and gain a seat at the table for the next round.
