This post is authored jointly with our friend and colleague, Thomas Philippon, Max L. Heine Professor of Finance at the NYU Stern School of Business

Deposit insurance is a key regulatory tool for limiting bank runs and panics. In the United States, the Federal Deposit Insurance Corporation (FDIC) has insured bank deposits since 1934. FDIC-insured deposits are protected by a credible government guarantee, so there is little incentive to run.

However, deposit insurance creates moral hazard. By eliminating the incentive of depositors to monitor their banks, it encourages bank managers to rely on low-cost insured deposits to fund risky activities. In the extreme, with 100% deposit insurance coverage, banks would have virtually no incentive to issue equity or debt.

Against this background, and in light of the events of March-April 2023, we ask what is to be done about deposit insurance. To prevent bank runs, should there be an increase in the legal limit? If so, how can authorities balance the costs of runs and panics against the costs associated with moral hazard, while keeping in mind the potential financial burden on the public? Or, are there alternatives?

We emphasize three promising ways to enhance deposit insurance: a higher insurance cap for small and medium-sized enterprises (SMEs), new resolution rules, and the option to purchase supplementary deposit insurance. In addition, and as regular readers of this blog might expect, we also think that higher capital requirements should be part of the solution: if we require that banks increase the degree to which they finance their assets with capital (rather than deposits), the risk of runs and panics would decline even without raising the cap on deposit insurance….

The Extraordinary Failures Exposed by Silicon Valley Bank's Collapse

The collapse of Silicon Valley Bank (SVB) revealed an extraordinary range of astonishing failures. There was the failure of the bank’s executives to manage the maturity and liquidity risks that are basic to the business of banking: they failed Money and Banking 101. There was the failure of market discipline by investors who either didn’t notice or didn’t care about the fact that the bank was severely undercapitalized for the better part of a year before it collapsed. There was the failure of the supervisors to compel the bank to manage the simplest and most obvious risks. And, there was the failure of the resolution authorities to act in mid-2022 when SVB’s true net worth had sunk far below the minimum threshold for “prompt corrective action.”

Waiting several quarters to act deepened the threat to the financial system, undermining confidence not only in many other banks but also in the competence of the supervisors. The extraordinary rescue actions last week by both the deposit insurer (FDIC) and the lender of last resort (Federal Reserve) are just a sign of the high costs associated with restoring financial stability when confidence plunges.

In this post we discuss each of these four failures, as well as the actions that authorities took to stabilize the financial system following the SVB failure. To anticipate our conclusions, we see an urgent need for officials to do at least five things:

First, to regain credibility, supervisors need to do an immediate review of the unrealized losses on the balance sheets of all 45 banks with assets in excess of $50 billion.
Second, they should perform a speedy and focused stress test on each of these banks to assess the impact on their true net worth of a sizable further increase in interest rates. Any bank with a capital shortfall should be compelled either to issue new equity or shut down. (To ensure the availability of the necessary resources, authorities will need to have a pool of public funds available to recapitalize banks that cannot attract private investors.)
Third, to restore resilience, Congress must reverse the 2018-19 weakening of regulation that allowed medium-size banks to escape rigorous capital and liquidity requirements.
Fourth, the authorities must change accounting rules to ensure that reported capital more accurately reflects each bank’s true financial condition.
Finally, policymakers should assess the impact on the financial system and on the federal debt arising from the now-implicit promise to insure all deposits in a crisis. To limit risk taking, correspondingly greater fees and higher capital and liquidity requirements should accompany any explicit increase in the cap on deposit insurance.

Bank Runs and Panics: A Primer

A bank promises its clients immediate access to cash. Depositors can redeem their funds on demand at face value—first come, first served. Other short-term creditors can do the same, albeit at varying speeds, by not rolling over their loans. And, households and firms that pay a fee for a credit commitment can take down their loans at will.

For banks that hold illiquid assets, these promises of liquidity on demand are the key source of vulnerability. The same applies to other financial institutions (de facto or shadow banks) that perform bank-like services, using their balance sheets to transform illiquid, longer-maturity, risky assets into liquid, short-maturity, low-risk liabilities.

A bank run occurs when depositors wish to make a large volume of withdrawals all at once. A bank that cannot meet this sudden demand fails. Even solvent banks—those whose assets exceed the value of their liabilities—fail if they cannot convert their assets into cash rapidly enough (and with minimal loss) to satisfy their clients’ demands. A banking panic is the plural of a bank run: when clients run on multiple banks. We call the spread of runs from one bank to others contagion—the same term used to describe the spread of a biological pathogen.

In this primer, we characterize the sources of bank runs and panics, as well as the tools we use to prevent or mitigate them….

Libra's dramatic call to regulatory action

Facebook’s June 18 announcement that it has created a Geneva-based entity with plans to issue a currency called Libra is sending shock waves through the financial world. The stated objectives of creating Libra are to improve the efficiency of payments and to ease financial access. While these are laudable goals, it is essential that we achieve them without facilitating criminal exploitation of the payments system or reducing the ability of authorities to monitor and mitigate systemic risk. In addition, any broad-based financial innovation should ease the stabilization of consumption.

On all of these criteria, we see Libra as doing more harm than good. And, for the countries whose currencies are excluded from the Libra portfolio, it will diminish seignorage, while enabling capital outflows and, in periods of stress, accelerating capital flight.

Like Bank of England Governor Carney, we have an open mind, and believe that increased competition, coupled with the introduction of new technologies, will eventually lower stubbornly high transactions costs, improving the quality of financial services globally. But in this case, we urge a closed door….

Italeave: The Renewed Threat of a Parallel Currency

In the March 2018 general election, two Italian political parties (the League and the Five Star Movement) that eventually formed the current government campaigned against many of the structures that are the foundation of the European Union. One part of their agreed policy program, a proposal that resurfaced in the past week, concerns the possibility of issuing mini-BOTs (which stands for Buoni del Tesoro). These would be small denomination “bonds”—non-interest-bearing, tradeable securities—issued by the Italian government to pay debts and usable to pay taxes or purchase goods and services provided by the state. Printed in the size and shape of currency notes, recipients could view them as a new means of exchange.

In this post, we discuss the possibility of Italy leaving the European Monetary Union, and why there is an increased incentive for the government to plan for an abrupt and unanticipated exit. The strategic analogy is to the appearance of a first-strike capacity that undermines nuclear peace. In our view, however, that appearance is misleading: any attempt to exit would not only be a disaster for Italy, as we explained in our post from a year ago, it would be the “mother of all financial crises” ….

FEMA for Finance

Modern financial systems are inherently vulnerable. The conversion of savings into investment—a basic function of finance—involves substantial risk. Creditors often demand liquid, short-term, low-risk assets; and borrowers typically wish to finance projects that take time to generate their uncertain returns. Intermediaries that bridge this gap—transforming liquidity, maturity and credit between their assets and liabilities—are subject to runs should risk-averse savers come to doubt the market value of their assets.

The modern financial system is vulnerable in a myriad of other ways as well. For example, if hackers were to suddenly render a key identification technology untrustworthy, it could disable the payments system, bringing a broad swath of economic activity to an abrupt halt. Similarly, the financial infrastructure that implements most transactions—ranging from retail payments to the clearing and settlement of securities and derivatives trades—typically relies on a few enormous hubs that are irreplaceable in the short run. Economies of scale and scope mean that such financial market utilities (FMUs) make transactions cheap, but they also concentrate risk: even their temporary disruption could be catastrophic. (One of our worst nightmares is a cyber-attack that disables the computer and power grid on which our financial system and economy are built.)

With these concerns in mind, we welcome our friend Kathryn Judge’s innovative proposal for a financial “Guarantor of Last Resort”—or emergency guarantee authority (EGA)—as a mechanism for containing financial crises. In this post, we discuss the promise and the pitfalls of Judge’s proposal. Our conclusion is that an EGA would be an excellent tool for managing the fallout from dire threats originating outside the financial system—cyber-terrorism or outright war come to mind. In such circumstances, we see an EGA as a complement to existing conventional efforts at enhancing financial system resilience.

However, the potential for the industry to game an EGA, as well as the very real possibility that politicians will see it as a substitute for rigorous capital and liquidity requirements, make us cautious about its broader applicability. At least initially, this leads us to conclude that the bar for invoking an EGA should be set very high—higher than Judge suggests….

What Should the Fed Own?

The Federal Reserve began to consider just how far its balance sheet consolidation should go well before the tapering actually began nearly a year ago. Earlier staff analyses pointed to a gradual runoff of long-term debt that could take years to reduce Fed assets to a new long-run equilibrium. More recently, market observers have speculated about an early end to consolidation that would result in a higher steady-state level.

Yet, as a recent Wall Street Journal article highlights, policymakers and analysts have devoted less attention to the mix of assets that the Fed should select once the balance sheet shrinks to its long-run equilibrium and policymakers allow it to expand slowly—say, in line with the increase of demand for currency.

In this post, we argue that the Fed should aim in normal times—when the economy is expanding and absent any financial strains—for a portfolio that has minimal liquidity, maturity and credit risk. In practical terms, this means that their portfolio should be composed largely of Treasury bills and short-term notes, with an average maturity that is very short….

Financial Crisis: The Endgame

Ten years ago this month, the run on Lehman Brothers kicked off the third and final phase of the Great Financial Crisis (GFC) of 2007-2009. In two earlier posts (here and here), we describe the prior phases of the crisis. The first began on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime debt, kicking off a global scramble for safe, liquid assets. And the second started seven months later when, in response to the March 2008 run on Bear Stearns, the Fed provided liquidity directly to nonbanks for the first time since the Great Depression, completing its crisis-driven evolution into an effective lender of last resort to solvent, but illiquid intermediaries.

The most intense period of the crisis began with the failure of Lehman Brothers on September 15, 2008. Credit dried up; not just uncollateralized lending, but short-term lending backed by investment-grade collateral as well. In mid-September, measures of financial stress spiked far above levels seen before or since (see here and here). And, the spillover to the real economy was rapid and dramatic, with the U.S. economy plunging that autumn at the fastest pace since quarterly reporting began in 1947.

In our view, three, interrelated policy responses proved critical in arresting the crisis and promoting recovery. First was the Fed’s aggressive monetary stimulus: after Lehman, within its mandate, the Fed did “whatever it took” to end the crisis. Second was the use of taxpayer resources—authorized by Congress—to recapitalize the U.S. financial system. And third, was the exceptional disclosure mechanism introduced by the Federal Reserve in early 2009—the first round of macroprudential stress tests known as the Supervisory Capital Assessment Program (SCAP)—that neutralized the worst fears about U.S. banks.

In this post, we begin with a bit of background, highlighting the aggregate capital shortfall of the U.S. financial system as the source of the crisis. We then turn to the policy response. Because we have discussed unconventional monetary policy in some detail in previous posts (here and here), our focus here is on the stress tests (combined with recapitalization) as a central means for restoring confidence in the financial system….

Italeave: Mother of all financial crises

After years of calm, fears of a currency redenomination—prompted by the attitudes toward monetary union of Italy’s now-governing parties and the potential for another round of early elections—revived turbulence in Italian markets last week. We have warned in the past that an Italian exit from the euro would be disastrous not only for Italy, but for many others as well (see our earlier post).

And, given Italy’s high public debt, a significant easing of its fiscal stance within monetary union could revive financial instability, rather than boost economic growth. Depositors fearing the introduction of a parallel currency (to finance the fiscal stimulus) would have incentive to shift out of Italian banks into “safer” jurisdictions. Argentina’s experience in 2001, when the introduction of quasi-moneys by the fiscal authorities undermined monetary control, is instructive….

Money Funds -- The Empire Strikes Back?

Shortly after Lehman failed in 2008, investors began to flee from money market mutual funds (MMMFs). To halt the run, the U.S. Treasury guaranteed all $3.8 trillion in outstanding MMMF liabilities. That rescue created enduring moral hazard: the expectation that a future crisis will lead to another bailout.

Aside from their legal form as mutual funds, MMMFs functioned much like banks engaged in the transformation of liquidity, credit and (to some extent) maturity. Similar to banks that redeem deposits at face value, they promised investors a fixed share value of $1 (a “buck”) on demand. Unlike depositories, however, MMMFs had no capital, no deposit insurance, and—at least officially—no access to the lender of last resort. So, when the Reserve Primary Fund “broke the buck” (by failing to redeem at the $1 par value) in September 2008, MMMF investors panicked.

Somewhat surprisingly, it took until 2014 for the Securities and Exchange Commission (SEC) to resolve political conflicts and introduce significant rule changes for MMMFs (see our earlier posts here and here). The SEC now requires that institutional prime MMMFs—which (like Reserve Primary) frequently invest in short-term corporate liabilities—operate like other mutual funds with a floating net asset value (NAV). The same rule applies to institutional municipal MMMFs. Retail MMMFs, as well as those investing in federal government (and agency) securities, are exempt.

In light of a recent legislative proposal to water it down, in this post we review the impact of the SEC’s 2014 reform. To highlight our conclusions: (1) it did not go far enough to reduce run risk; (2) aside from temporary dislocations, it has not raised nonfinancial sector funding costs by more than would be accounted for by reducing the implicit taxpayer guarantee for MMMFs; and (3) reversing the floating-NAV requirement would weaken the safety of the U.S. financial system....

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Money, Banking, and Financial Markets