In the ’80s, it paid off uninsured depositors at 80%.
While the government’s quick action to protect depositors at Silicon Valley Bank and Signature Bank somewhat calmed fears of a financial meltdown, it also raised new concerns of instability. The Federal Deposit Insurance Corp. would’ve been better off taking a page out of the 1980s.
Banking necessarily involves taking short-term savings from depositors and investing them in longer-term loans to families and businesses. Because the deposits come due sooner than the loans, no bank could repay all its depositors in the short run. The Federal Reserve is in place, in part, to help banks meet these short-term liquidity needs.
Upon a bank’s failure, the FDIC promptly pays in full all insured depositors, but there are usually a fair number of accounts that exceed the agency’s $250,000 deposit insurance cap. These people and businesses can be left scrambling, which can roil the economy into a panic and potentially herald a major economic downturn.
That’s why the FDIC stepped in to cover fully even those depositors who were uninsured at SVB and Signature. But putting a 100% guarantee of those banks’ rich mega-depositors on the FDIC’s tab was terribly unwise. If the government protects every depositor in a bank failure, even those who are rich and sophisticated enough to have known better, it erodes marketplace discipline and makes banks less stable going forward.
Instead, the FDIC should have turned to its 1982 innovation: the modified deposit payoff. The idea was that when a bank closed, the FDIC would pay uninsured depositors the full insured amount—today $250,000—and give them receivership certificates for 80% of their uninsured funds, which was the minimum amount large depositors historically recovered from failed bank receiverships. Large depositors could then take that certificate to Federal Reserve banks and exchange it for cash. If the FDIC ultimately collected more than the 80% from the failed bank receivership, it’d pay large depositors those extra funds until they were made whole.
This would ameliorate the damage a bank failure inflicts on the economy without creating the moral hazard accompanying a 100% guarantee. Uninsured money that would otherwise sit idle for years at the failed bank receivership would be returned promptly to the local marketplace to support economic growth.
The government should have used modified deposit payoffs in the case of SVB and Signature. The FDIC can, and has in the past, used modified deposit payoffs without new legislation. Though that opportunity has passed, it could make clear to the public that it will use that tool in any future failures as far as it’s feasible.
It would be even better if Congress passed the provision explicitly into law, with another critical reform: All non-interest-bearing checking accounts held by individuals or businesses should be fully insured—no matter how large. Such funds aren’t chasing high yields or taking large risks. This reform would protect business accounts that are essential to keeping the economy moving and would reduce substantially the risk of panics.
No one loses under this plan—not American savers, workers, or taxpayers.
Mr. Isaac was chairman of the Federal Deposit Insurance Corporation (1978-86) and Fifth Third Bancorp (2009-14) and is chairman of Secura/Isaac Group and related financial consulting companies.
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Appeared in the March 29, 2023, print edition as ‘A Proven Way to Avoid Moral Hazard’.