The End of Market Discipline for Banks

Janet Yellen essentially says all deposits are insured. From now on, moral hazard rules.

This is an interesting article. It mentions that there are currently $17.6 tln in U.S bank deposits. However, on 12/31/22 the FDIC's Deposit Insurance Fund had assets of $128.3 bln on hand to cover insured depositors. What will make up for a potential shortfall?

Financial regulators have ignored their post-2008 rule book to contain the latest banking panic. And on Tuesday Treasury Secretary?Janet Yellen?tore it up by announcing a de facto guarantee of all $17.6 trillion in U.S. bank deposits. Regional bank stocks rallied, but it’s important to understand what this moment means: the end of market discipline in U.S. banking.

“Our intervention was necessary to protect the broader U.S. banking system,” Ms. Yellen told the American Bankers Association convention. “And similar actions could be warranted if smaller institutions suffer deposit runs that pose the risk of contagion.”?

Translation: Depositors needn’t worry about the safety and soundness of banks. Uncle Sam will make sure you don’t lose money.?

This isn’t an explicit guarantee, but it’s close enough for government work. Dodd-Frank lets the Federal Deposit Insurance Corp. guarantee uninsured deposits under its “systemic risk” exception.” But banks must fail for the exception to apply and the systemic risk is supposed to be genuine. Regulators stretched that exception with?SVB?and Signature, and the Treasury Secretary is now making clear that they will stretch it again to prevent more bank runs on her watch. Ms. Yellen would court criticism in Congress if she straight up declared a guarantee for all uninsured deposits, but it’s now clearly implied.

But why does she feel the need to provide this assurance if “the situation is stabilizing, and the U.S. banking system remains sound,” as she claimed? Perhaps because bank depositors and investors fear the trouble in banks is wider than she claims.

A stable financial system requires clear and transparent capital standards, sound regulation, and above all market discipline to punish reckless behavior. The current panic has shown that none of those exist in the U.S.

Risk-weighted capital standards have made banks look healthier than they are. The Dodd-Frank regulatory architecture failed to protect against the interest-rate risk that landed Silicon Valley (SVB), Signature and First Republic banks in trouble. Market discipline fell sharply with the creation of too-big-to-fail banks as part of Dodd-Frank. Now Ms. Yellen is throwing out residual discipline by telling even uninsured depositors that they needn’t worry.

The consequences will be far-reaching even if the damage isn’t immediately clear. Bank executives won’t have an incentive to manage conservatively if they know their deposits aren’t at risk of fleeing. Large depositors will be less likely to spread their cash across multiple banks. Deposits and risk could become more concentrated at poorly managed banks that offer more customer perks, as happened at SVB.?

Sen.?Elizabeth Warren?says no one should expect small businesses with more than $250,000 in cash to be savvy enough to know the difference between a well and poorly run bank, so deposits should be guaranteed. “The one exception I might draw to that is the billion-dollar depositor,” she told Roll Call.

But most mom-and-pop businesses don’t have more than $250,000 sitting in the bank. The small businesses she’s referring to are hedge funds, venture and law firms and well-funded startups. Many VCs didn’t do due diligence before parking money at SVB, but it’s not unreasonable to expect that they should.

Letting uninsured depositors at SVB and Signature take a modest haircut would have provided useful market discipline. The Administration is doing the opposite. It’s creating moral hazard that will seed future trouble by encouraging more risky behavior by bank management and reducing caution among depositors, investors and creditors.

The Administration is presenting its intervention as a one-off. But once regulators do something, they create the market expectation that they will do it again. And if they don’t, the ensuing market panic will invariably impel them. Biden officials are crossing a Rubicon here, and they’re doing it essentially by fiat without approval by Congress.

Regulators have become all too accustomed to doing anything they want during a market panic, reaching for extraordinary power even in non-emergencies. Ms. Yellen may have shored up confidence in midsize banks, but the cost of her guarantee will be a less sound and safe U.S. banking system.

Appeared in the March 22, 2023, WSJ print edition as 'The End of Market Discipline for Banks'.