by Simon Johnson
Do we have a banking crisis in the United States or don’t we?
We certainly have some of the symptoms, including two prominent banks that just failed and downward pressure this week on the share prices of other midsize banks. Yet on Wednesday, the Federal Reserve raised interest rates by .25 percentage point — which is not what you would expect a central bank to do in a crisis.
Also on Wednesday, Treasury Secretary Janet Yellen indicated that expanding deposit insurance is “not something that we’re considering” — and this is not what you would expect the country’s most experienced economic policy maker to say in a crisis.
We’re in trouble, but not the kind of trouble we experienced in the global financial crisis of 2007-08. There’s still time to take effective evasive action, particularly by extending deposit insurance in an appropriate and timely manner. If we don’t act quickly, we could find ourselves on a prolonged and steeper downward path — with damaging effects for the economy.
The collapse of Silicon Valley Bank on March 9 was sudden — reminiscent of the swift end of Lehman Bros. in September 2008. There are also other parallels, including badly managed risk and a failure of appropriate supervision. But the differences are also quite profound. Lehman’s creditors took losses as did some people who lent money to SVB (for example, holders of bonds issued by SVB’s parent company), but uninsured depositors in the bank itself were protected by a government intervention on March 12.
After Lehman’s bankruptcy, there was a rapid repricing of assets and a massive flood of money moving “to safety” — which meant a shift of funds away from many parts of the financial system and into deposits at the largest banks. That fast move helped trigger a major contraction in credit.
This time, money has again moved into JP Morgan Chase and about 10 other banks presumed by the investing public to be too big to be allowed to fail. But that movement, so far, is much smaller than in 2008, in part because uninsured depositors at SVB and Signature Bank, which failed the same weekend, did not face losses, and in part because that government action implied protection could be provided to other uninsured depositors at other banks, if the need arises. On Monday, Yellen said, “similar actions could be warranted if smaller institutions suffer deposit runs that pose the risk of contagion.”
Unfortunately, such implicit promises are unlikely to stop the slow bleed of deposits out of regional banks. On our current trajectory, business confidence is likely to erode and potential recession looms. The Biden administration’s signature reindustrialization agenda, embodied by the 2022 Chips and Science Act, is likely to falter if the health of regional banks is threatened. These banks are important lenders to those parts of the manufacturing and services sectors that this legislation is designed to help. The big banks are unlikely to be able to fill this gap.
Rather than giving uninsured deposits at troubled banks emergency protection, a simple way to protect the U.S. economy would be to increase deposit insurance on all accounts, a measure that would require an act of Congress. A blanket guarantee for all deposits, however, could lead to new hazards, such as speculators putting hundreds of millions of dollars “on deposit” with banks promising impossible returns.
As Sheila Bair, former head of the Federal Deposit Insurance Corp. (FDIC), has pointed out, what is needed is to insure transaction accounts (known as operational deposits), which is the money used by businesses to make payroll, pay vendors and cover the rent. Asking small businesses to monitor closely the banks with whom they work does not seem reasonable. A similar measure was included as part of the 2020 Cares Act to reduce the risk of financial crisis during the COVID-19 pandemic.
Expanding deposit insurance in this direction has gained supporters on Capitol Hill over the last week, led by Rep. Ro Khanna, D-Calif. If Khanna can persuade one or more prominent Republicans to join this effort, it could quickly gain traction on Capitol Hill. Though there are some encouraging signs, it is not clear who will step up to protect small businesses in a sensible and timely fashion.
Members of the Republican House Freedom Caucus might block such a measure from coming to a vote. But fortunately, a provision of the 2010 Dodd-Frank Act allows expedited approval by Congress to authorize expanded deposit insurance from the FDIC.
Increasing the deposit insurance cap and focusing on small business transaction accounts could stabilize midsize banks, reduce more deposit transfers out of those institutions, and shore up confidence in the banking system. If there is enough support in Congress, the Biden administration should submit a request for rapid approval. Without this fix, the odds increase for more turmoil in the banking system.