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Failing Banks and the Need to Protect the Public’s Cash

Letting all depositors off the hook creates a moral hazard, but taxpayer money should be protected. If Congress won’t extend full insurance to states and localities, banks should be required to protect those deposits with their own collateral.

An SVB security guard looking through a window with "svb" and "Main Lobby" written on it.
A security guard looks out as customers seeking to withdraw their deposits line up at Silicon Valley Bank headquarters in Santa Clara, Calif., on March 13, 2023. More than 500 U.S. banks have failed since 2009. (Noah Berger/AFP/Getty Images/TNS)
The Bank Panic of 2023 started three weeks ago and ran like wildfire through the high-tech business community and the regional bank industry as Silicon Valley Bank, a national leader in lending to startup businesses and venture capitalists, suffered a two-day run on its deposits after announcing megabillion-dollar losses in its bond portfolios. Big depositors yanked $42 billion from the bank in just one day before it was shut down.

Fortunately for SVB’s uninsured depositors, federal agencies stepped in over the following weekend to prevent contagion by promising full recovery to that bank’s depositors and extending lifelines to others, at the expense of the entire banking industry, whose investors will foot the bill through special assessments to the Federal Deposit Insurance Corp. fund that are allowed in special cases of “systemic risk” to the U.S. economy. Treasury Secretary Janet Yellen is considering possible emergency measures for smaller banks.

As it happens, few if any states or localities had money with SVB, so in this case their treasurers were mostly watching from the sidelines. But on any given day, hundreds of billions of taxpayer dollars are on deposit with other banks across the country. What happened with SVB, and a couple days later with Signature Bank, should be nightmarish enough to keep a prudent state or local financier up at night. Imagine the poor city treasurer who just sold bonds to fund a capital project, and the incoming wire transfer came to a local bank that just happened to fail that day before the cash could clear to be invested in treasury bills. Or the hapless metropolitan county treasurer who just collected millions in property taxes from the mortgage escrows of its local taxpayers on the due date and learns that its bank just closed.

So let’s not let this crisis go to waste. There’s an important lesson for public officials: Some form of protection for the public’s cash should be required by all states and preferably by Congress. Ideally, if deposit insurance is not made universal permanently, a nationwide system would protect public funds by segregating a portion of each bank’s government securities portfolio as collateral for at-risk state and local government deposits.

The industrywide problem that has been brought to light this month is that uninsured depositors can feed a bank run that threatens the entire financial system. In the case of Silicon Valley Bank, a huge percentage of its deposits were large accounts well above the $250,000 FDIC insurance limits. Although the federal promise to let these large depositors off the hook for their uninsured exposure provided immediate relief, it now creates a moral hazard.

The FDIC insurance program has arguably been hijacked so that larger and well-capitalized banks must contribute to the insurance fund to bail out busted and zombie banks. That policy calms the waters today, but it may not be sufficient in a future period of widespread economic stress. Today’s expedient and temporary Band-Aid arrangement seems both unfair and unsustainable on its face.

That’s why public treasurers need permanent solutions to protect taxpayer funds. Imagine if prison corrections officers and local jailkeepers were to walk off the job because their paychecks bounced, leaving the inmates in charge. It’s just one reason that hundreds of responsible public treasurers nationwide have already established a secondary source of liquidity and a backup bank account. But as prudent as those steps are, they aren’t universal and they wouldn’t protect every taxpayer dollar in the event of a true nationwide banking catastrophe.

Vital Transactions

For those who think the problem of bank failures is overblown, chew on this: Since 2009, there have been 513 banks that failed in the U.S. The skeletons of Darwinian capitalism litter this industry, despite banking laws, regulations and supervision.

A prosperous modern economy needs a financial system through which large payments can be safely transmitted without fear of a bank collapse. There is a long list of big banks with about half of their deposits uninsured. They have uneven levels of “fortress capital” — surplus reserves — and dozens of them now hold underwater assets. The American economy cannot play musical chairs and Russian roulette with institutional-size transactions flowing through an opaque banking network.

The point here is that transactional deposits, such as the taxpayer funds moving through the system, are not stagnant cash, but the banking system today makes no distinction of that reality. Idle funds and crony “relationship balances” of the business elite are given the same protections as the active working capital that is so vital to our economy. By default, today’s patchwork system now protects slothful cash management and rewards deposit brokerage platforms moving “hot money” around, as well as myopic bank managers who exploit the FDIC system.

The recent bank failures will likely put heat on Congress to extend deposit insurance to all accounts, or at least to raise the insured limits. That simplistic policy approach has its fans, but also some big flaws. Higher FDIC limits of, say, a million dollars would still not address the scenarios cited above. And a limitless FDIC regime would reward the weak banks, lunkheads and lazy cash managers at the expense of stronger, prudent banks and their stakeholders if it’s funded by indiscriminate assessments on the entire industry.

The problem is protecting the beast’s muscles but not its blubber and parasites.

Variations on the insurance model are percolating. A recently televised “expert’s” proposal to establish “tiered pricing” for various levels of FDIC insurance would have the same perverse result of subsidizing undisciplined bankers and feckless depositors while shifting costs to the money-center banks. So one money manager has suggested that regulators charge a completely new and separate systemwide insurance fee for deposits over $250,000 that by law would pass through directly to the consumers and investors as their cost of holding deposits or buying bank CDs. In theory that would minimize moral hazards, but it would require broad bipartisan and industry support on Capitol Hill. It’s the better version of several systemwide insurance options now circulating, but that still poses a design challenge of assigning risk-based costs equitably to depositors.

Precedents for Collateralization

Decades ago, in an era when FDIC insurance limits were much lower and bank failures had scared enough state legislators and public treasurers to demand statutory action, a number of states required public deposit collateralization. These laws typically provide for either 1-to-1 matching of specific securities with a public depositor in a restricted account, or a pool of such assets to backstop all public deposits. Colorado and Minnesota are two examples. If a bank fails in those states, public deposits have first dibs on the collateral. At least a dozen states have such laws on the books today.

The Government Finance Officers Association issued a policy statement in 2019 to reaffirm the importance of these programs. I can remember back to my days on the GFOA staff in the 1980s when we had several large bank failures, and the policy committees were exploring various models for statewide collateral pools and other ideas for states to consider. It’s now time to dust off the good work done back then and refresh it.

The only sensible alternative to fully collateralizing all state and local government deposits is to extend FDIC insurance to all public-sector accounts without limits. That could be done with the stroke of a congressional pen, which arguably would be the simplest solution. State and local governments’ bank deposits, amounting to about $700 billion, represent only about 4 percent of the total nationwide. But that carve-out strategy could fail on Capitol Hill because of the copycat “me too” lobbying from other industry groups that pile on to the point of legislative overload, where the math just won’t work because of the sheer magnitude of all jumbo bank depositors seeking a free ride. So a more targeted collateral backstop for only public-sector deposits is a lower-cost alternative.

A 2008 report in the FDIC Quarterly discussed the pros and cons of both approaches, with a section highlighting some alternatives for collateralization. It is well worth revisiting by public finance professionals, state and local elected officials and their national association leaders.

It’s noteworthy that the federal government does not mess around with this problem in its own backyard. Federal laws and rules require U.S. Treasury and other government agency bank deposits to be collateralized, and the feds have a set of rules to oversee and regulate the national bank deposit collateralization programs. So this is not a new concept for Uncle Sam’s money. What’s good for protecting the Treasury’s goose should be equally good for the municipal gander.

The public finance community can take the lead in advocating state laws where needed, and more importantly, a new federal rule for the bankers’ playbook that could apply to all public-sector deposits. As you’ll see, this can be done without burdening the best-run banks.

At the state level, treasurers should look to their counterparts in other states to find public deposit collateralization laws that best suit their local circumstances. There are plenty to pick from with an abundance of variants. Ideally, the professional associations like GFOA and the two prominent national associations of state treasurers and other financial officials [the National Association of State Treasurers (NAST) and the National Association of State Auditors, Comptrollers and Treasurers (NASACT)] can provide some model statutes or a conceptual framework for state legislative staff.

A Practical Solution

At the national level, here’s an outline of how the problem could be solved with the least moral hazard, maximum efficiency, lowest friction and least cost to the banking industry:

• Require all public-sector deposits at FDIC-insured banks which exceed the coverage limits to be collateralized by a pool of that bank’s marketable portfolio securities unless its capital and liquidity metrics exceed a precautionary regulatory threshold. A surprising majority of large banks would fail this test today if market prices were applied to their portfolio assets, according to an industry report cited recently in a Barron’s table, so this is not a trivial measure. But those that have built fortress balance sheets should be exempt from collateralization requirements unless they slip below rigorous regulatory acid-test levels because of asset portfolio degradation.

• To calculate the collateral pool requirement, officials can use a weekly maximum of total covered uninsured public deposits. This would not protect every dollar that might be trapped in a bank failure on any given day, but it would protect the vast majority of such uninsured accounts and the FDIC fund itself. Public treasurers should also be required to notify their bank in writing of highly predictable upcoming large cash inflows that require short-term collateralization for a few days in transit. Tax collection deadlines and bond issues are examples.

Under this approach, banks that meet stringent capital-adequacy tests would be left free to operate their business without collateralizing their uninsured deposits. Otherwise, marketable portfolio assets should be assigned to a collateral pool, while also triggering heightened supervision and capital preservation rules. Those rules could include a freeze on stock buybacks and stock option awards, and would be imposed before a bank collapses — not after.

This model may not be perfect, but it can provide a starting point for thoughtful dialogue and refinement by policy advocates and legislators. Unless unlimited FDIC insurance for states and localities becomes the standard under federal law, their deposits deserve full collateralization nationwide. Congress should enact one or the other now, before something breaks.

Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.
Girard Miller is the finance columnist for Governing. He can be reached at
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