The Sunday policy actions by the Treasury, Fed, and FDIC are among the most unwise and unprincipled actions of bank regulators in U.S. history. And they don’t address the urgent need for additional action to prevent further banking troubles.
The first policy was the FDIC’s decision to fully insure all the uninsured deposits at two failed banks. The rescue of uninsured depositors cannot be justified economically. Neither of the failed banks was systemically important; it is not possible to argue that uninsured depositor losses in these institutions would have any significant consequences elsewhere in the financial system. The authorities missed a great opportunity to reinforce market discipline by allowing at least some losses on the uninsured deposits at two banks that clearly are not systemically important. The bailout of these banks’ uninsured deposits seems best understood as a political choice to prevent politically influential Silicon Valley firms from having to suffer delayed access to their funds or any risk of loss.
Furthermore, these bailouts have no clear implication for the risk of loss to uninsured depositors at other banks, and therefore, will have little calming effect on other potential runs. About two hundred other banks appear to be at risk of similar problems (see https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4387676).
The second policy announcement is even more puzzling. The Federal Reserve created a new special lending facility for banks, allowing them to borrow for up to one year against qualifying Treasury and Agency securities. Banks can borrow an amount equal to the face value of those securities, which exceeds their market value. This implies a partially non-collateralized loan (the opposite of the typical “haircut” applied to collateral in central bank lending).
The announcement claimed that this would alleviate illiquidity problems for banks, thereby helping them weather the storm, but that seems unlikely for two reasons: First, the decline in the value of the securities is not temporary but is fundamentally the result of Fed interest rates changes, which are not only going to persist but will be increased going forward. This collateral is not going to increase in value as the result of the policy change. Second, the loan is only for a year, so after the end of that year, a bank that is insolvent today because its securities have fallen in value will still be insolvent. For these reasons, it is hard to see how the Fed lending program would cause uninsured depositors at an insolvent or deeply weakened bank to decide not to withdraw their funds immediately, if they were already predisposed to do so.
This new Fed policy also runs counter to the spirit, if not the letter, of the law in two important respects. First, in both 1991 and 2010, the FDICIA and Dodd-Frank legislations made clear that the Fed should not lend to insolvent institutions, since doing so tends to encourage weak institutions to take on excessive new risks, increasing the ultimate losses to the FDIC from resolving them. Yet the intent of this new Fed program is precisely to delay weak or insolvent institutions’ day of reckoning for a year (although, as I argued, it probably won’t). Second, the Dodd-Frank Act of 2010 placed strict limits on non-collateralized lending by the Fed. Given that this new lending program allows the Fed to lend on a partly non-collateralized basis, this also seems to violate the spirit of that limitation.
The Treasury-Fed-FDIC announcement was at pains to say that the bailout of the two banks’ uninsured depositors would not be taxpayer funded. A special FDIC assessment on healthy banks, paid for by their depositors, will fund the bailout. The Fed loan, however, is directly backed by $25 billion in Treasury support through the Exchange Stabilization Fund (ESF). It is also unclear how much the taxpayers will have to pay to foot the bill. The $25 billion of ESF support may not be enough to cover the potential losses, especially given that interest rates on these securities are likely to continue to rise, driving a growing wedge between their face value and market value.
What could policymakers have done instead? To restore confidence in remaining banks regulators should have shut down or required the immediate recapitalization of all severely under-capitalized banks. Then they could have credibly announced that they are confident that no other banks are at risk of immediate failure. This is not hard to do, given that banks’ securities portfolios are examined regularly. As it is now, depositors know that the government has chosen not to deal with the problem, which makes them justifiably worried about their own banks.
Second, officials could have reminded people that future systemic problems would be dealt with using Title II of Dodd-Frank, if necessary. That would at least have reassured uninsured depositors at too-big-to-fail banks they are protected against loss.
Third, they could have pointed out that many banks where uninsured deposits are held are members of a network for swapping deposits, which would allow uninsured deposits to be transformed into insured ones.
Fourth, to help uninsured depositors at the two failed banks, they could have announced that they would allow immediate limited access to some of those uninsured deposit balances (based on knowledge of what a reasonable lower bound for recoveries will be).
Instead, the Treasury-Fed-FDIC announcement did not solve the big remaining problem, while doing significant unnecessary harm
