Why Wall Street Should Be Skeptical About Expanding FDIC Coverage

When does systemic risk trump moral hazard? Today’s banking crisis has sparked questions among investors, banks, lawmakers, and regulators about whether the Federal Deposit Insurance Corporation’s $250,000 deposit insurance cap should be raised or temporarily suspended. Such a move would be a major escalation of government intervention into the banking system. It wouldn’t be easy to do.

After the collapse of Lehman Brothers in 2008, then-Treasury Secretary Hank Paulson had a change of heart. AIG was collapsing, credit markets were seizing up, and everything seemed on the brink of doom. For a free-market Republican like Paulson, the health of the financial system took precedence over any argument against the moral hazard of rewarding bad financial decisions by banks.

“Unless you act, the financial system of this country and the world will melt down in a matter of days,” Paulson reportedly told a group of lawmakers as he pushed Congress to pass the $700 billion Troubled Asset Relief Program. The House failed to pass it the first time, leading to the largest stock market decline ever at the time. That swayed enough conservative and progressive holdouts to vote for it soon after.

Federal regulators knew they needed to get approval from Congress instead of just taking unilateral action. When Paulson was coming up with the TARP program, then-Federal Reserve Board Chair Ben Bernanke told him, “You have to go to Congress. We can’t do this anymore on a case-by-case basis.”

Fast forward to the current crisis: Bloomberg News first reported that federal officials are studying whether emergency powers can be used to temporarily expand the FDIC deposit insurance cap without approval from Congress.

What’s theoretically possible is different from what’s politically practical. Congress sought to make clear in Section 1105 of the Dodd-Frank Act (later amended by the CARES Act of 2020) that lawmakers’ input was necessary on any widely available program to guarantee the obligations – including deposits – of banks.

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Going against the spirit of the law only invites accusations that regulators are doing bailouts without the consent or vote of elected officials.

Regulators today aren’t ready to declare moral hazard subservient to systemic risk like in 2008. In her remarks at the American Bankers Association’s Washington D.C. Summit, Treasury Secretary Janet Yellen said, “The situation is stabilizing. And the U.S. banking system remains sound.” She noted the recent developments today are “very different” from the Global Financial Crisis in 2008. The action regulators took to backstop Silicon Valley Bank and Signature Bank
SBNY
– a “systemic risk exception” to protect all depositors at the two banks – remains an option for institutions experiencing bank runs that risk contagion.

Yellen is undertaking a balancing act on messaging. She didn’t hint at a broader expansion of deposit insurance. But politically speaking, regulators can’t afford to not fully guarantee any bank that currently experiences a depository run in this environment. The optics of saving SVB
VB
— an institution that caters to tech and venture capital — but not a smaller community bank would be challenging. Regulators hope that by acting on a case-by-case basis, markets get the implicit message that all deposits are insured without the explicit headache of a system-wide expansion of deposit insurance.

However, there’s a risk that the system could fail for close to 190 banks, per new academic research. So, what happens then? Regulators are loath to go down this path and will only do so if they find themselves facing a banking crisis on a level tantamount to 2008. In such an event, systemic risk would trump moral hazard and they may pursue a formal program guaranteeing all of the uninsured deposits of all banks.

Like with TARP in 2008, regulators may put the onus on Congress to support them in this new program or bear their own political (and market) risk for failing to act. Is Congress up to the task?

Several Democrats and even some Republicans are in support of expanding the deposit insurance limit. House Financial Services Committee Chair Patrick McHenry (R-N.C.) said on CBS’ “Face the Nation” that he plans to look into the $250,000 cap. However, there’s a crosscurrent of opposition. Members of the House Freedom Caucus, a far-right bloc of Republicans, released a statement saying they “oppose any universal guarantee on bank deposits over the current limit.” The powerful Independent Community Bankers of America decried any expansion on depository insurance that is financed by assessments on small community banks. Even a temporary expansion means regulators would look for an off-ramp to ensure depositors will remain at small- and mid-sized banks. That could very well mean stricter banking regulations that Republicans abhor.

The devil is in the details, and an issue like expanding deposit insurance could languish unless there is a palpable sense that a systemic crisis is imminent without congressional action. It’s up to regulators to make the case if and/or when that time comes. Whether they can make the case before a Republican-controlled House remains to be seen. Just like in 2008, it may take another market crash for regulators to get their point across that action is necessary.