Senators Bill Hagerty and Angela Alsobrooks have introduced legislation that would raise the FDIC deposit insurance limit on noninterest-bearing transactions account balances from $250,000 to $10 million. This increase has the support of Treasury Secretary Scott Bessent and Senator Elizabeth Warren. Raising the deposit insurance limit without charging an actuarially fair premium for the additional insurance coverage creates moral hazard risk for the FDIC deposit insurance fund (DIF). This risk can be mitigated if newly insured fund balances are required to be deposited in the Federal Reserve and a share of interest earned on these deposits is passed through to the DIF.
The Hagerty-Alsobrooks legislation will help smaller banks retain their big business customers and remain viable in a banking system increasingly dominated by the so-called global systemically important banks (GSIBs). The legislation raises the deposit insurance limit to $10 million on business transaction accounts that do not pay interest, provided the bank’s parent is not a GSIB nor an insured branch of a foreign bank. For 10 years after the legislation takes effect, banks with assets under $10 billion are explicitly excluded from paying any additional insurance premia for this higher insurance coverage.
The FDIC’s report, “Options for Deposit Insurance Reform, does not endorse a large increase in the deposit insurance limit. Higher insurance coverage can encourage excessive bank risk-taking, bank failures, and insurance fund losses notwithstanding extensive federal resources devoted to bank supervision and regulation.
Both the FDIC and insured bankers agree that the deposit insurance framework needs to be revised, although neither suggests raising the insurance cap to $10 million. The FDIC reports that the current $250,000 insurance limit covers, by number, 99 percent of all retail deposit accounts. The Independent Community Bankers Association supports the Hagerty-Alsobrooks legislation—as long as their members do not have to pay insurance premiums for the additional coverage for 10 years. The premiums required to increase DIF balances and any fund losses that accrue from the increase in insurance coverage will be born by the largest banks.
The FDIC and the American Bankers Association recommend that any new insurance cap on transaction account balances be data-driven—set based on the actual size-distribution of business transaction account balances held by the community banks that would benefit. Few community banks have business transaction accounts with balances as large as $10 million.
Unless the FDIC charges an actuarially fair insurance premium for the new insurance coverage, the additional insurance gives banks an incentive to take on risky investments. When deposits have an FDIC guarantee, banks can borrow depositors’ money at the risk-free rate—or even at zero interest in business transactions accounts—regardless of how banks invest that money. When a bank invests in risky activities that promise fat yields, when the investments perform, the bank profits. If the investments sour, the bank may fail and force the FDIC to cover insured depositors’ losses. This well-known phenomenon is the moral hazard problem.
Moral hazard is not an issue if the FDIC charges banks actuarially fair deposit insurance premia. Actuarially fair insurance premia increase in lockstep with bank investment risk. However, even the FDIC admits, setting actuarially fair insurance premia is virtually impossible. The FDIC has neither the resources nor the staff to fully understand and accurately price the investment risk of each of its insured depositories. Moreover, banks’ risk exposures are often opaque until they become acutely problematic, and with today’s financially-engineered instruments and derivative markets, bank risk profiles can change quickly.
The FDIC recognizes that its deposit insurance assessment systems fail to upcharge for some of the most obvious risks a bank poses for the DIF. For example, FDIC assessment systems do not automatically raise insurance premiums when a bank’s investments have large unrealized interest rate losses. Nor do banks face higher insurance premia when they face enhanced run-risk because a large share of their deposits is uninsured.
Signature Bank and Silicon Valley Bank (SVB) raised most of their funds from business deposits in noninterest-bearing accounts. Both banks had large unrealized interest rate investment losses and high run-risk, and yet neither bank faced insurance premium charges commensurate with these risks. Congress should not pass legislation that promotes the growth of new risky banks like Signature and SVB—two of the most-costly bank failures in FDIC history.
There is a way to increase the deposit insurance limit to help smaller banks retain large business transaction accounts without increasing moral hazard risk to the DIF. Banks could create and offer new noninterest-bearing transaction accounts that are FDIC insured up to $10 million. To qualify, account balances above the current $250,000 limit must be deposited in the bank’s Federal Reserve master account. These risk-free deposits will earn the Fed’s IORB rate.
There will be debate as to the appropriate share of the IORB interest earned on these balances banks are allowed to keep. While the bank pays depositors no interest on these balances, it should be allowed to retain enough interest earnings to defer the bank’s cost of servicing the account. The remaining interest should be passed through to the DIF to provide the funding required for the DIF balance to comply with current law. If Congress decides to explicitly subsidize community banks, Congress could allow the banks to keep a larger share or even the entire IORB interest earnings on these balances and raise any additional required DIF funding from large banks.
This new transaction account would have full FDIC insurance up to $10 million: the first $250,000 insured under current arrangements and insurance premium assessments; the remaining balance up to the $10 million cap guaranteed by the new investment restriction. By requiring new insured balances over $250,000 to be invested in risk free assets and passing on some IORB interest payments to the FDIC, the DIF is compensated for the new exposure and the bank is prohibited from investing its newly-insured balances in risky investments.
The decision to offer these new transaction accounts should be optional, but the option would allow community banks to remain competitive in serving their large business customers and remove the moral hazard risk to the DIF that will otherwise be created by increasing the transaction account insurance limit to $10 million.
