Federal Deposit Insurance Corporation

Reforming the Federal Home Loan Bank System

We authored this post jointly with our friend and colleague, Lawrence J. White, Robert Kavesh Professor of Economics at the NYU Stern School of Business.

Some government financial institutions strengthen the system; others do not. In the United States, as the lender of last resort (LOLR), the Federal Reserve plays a critical role in stabilizing the financial system. Unfortunately, their LOLR job is made harder by the presence of the Federal Home Loan Bank (FHLB) system—a government-sponsored enterprise (GSE) that acts as a lender of next-to-last resort, keeping failing institutions alive and increasing the ultimate costs of their resolution.

We saw this dangerous pattern clearly over the past year when loans (“advances”) from Federal Home Loan Banks (FHLBs) helped postpone the inevitable regulatory reckoning for Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank (see Cecchetti, Schoenholtz and White, Chapter 9 in Acharya et. al. SVB and Beyond: The Banking Stress of 2023).

From a public policy perspective, FHLB advances have extremely undesirable properties. First, in addition to being overcollateralized, these loans are senior to other claims on the borrowing banks—including those of the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve: If the borrower defaults, the FHLB lender has a “super-lien.” Second, there is little timely disclosure about the identity of the borrowers or the amount that they borrow. Third, they are willing to provide speedy, low-cost funding to failing institutions—something we assume private lenders would not do.

In this post, we make specific proposals to scale back the FHLB System’s ability to serve as a lender to stressed banks….

Read More

Making Banking Safe

The regulatory reforms that followed the financial crisis of 2007-09 created a financial system that is far more resilient than the one we had 15 years ago. Today, banks and some nonbanks face more rigorous capital and liquidity requirements. Improved collateral rules for market-making activities can dampen shocks. And, some institutions are subject to well-structured resolution regimes.

Yet, the events of March 2023 make clear that the system remains fragile. The progress thus far is simply not enough. What else needs to be done?

In a new essay, we address this critical question. Our assessment of the banking system turmoil of 2023 leads us to several obvious conclusions, some of which clearly escaped both bank managers and their supervisors. Perhaps the simplest and most significant is that banks can survive either risky assets or volatile funding, but not both. Another is that supervisors are willing to treat some banks as systemic in death, but not in life.

We also draw two compelling lessons from the recent supervisory and resolution debacles. First, a financial system which relies heavily on supervisory discretion is unlikely to prove resilient. Second, authorities with emergency powers to bail out intermediaries during a panic will always do so. That is, policymakers are incapable of making credible commitments to impose losses on depositors and others. In our view, the only way to address this commitment problem is to prevent crises….

Read More

The Extraordinary Failures Exposed by Silicon Valley Bank's Collapse

The collapse of Silicon Valley Bank (SVB) revealed an extraordinary range of astonishing failures. There was the failure of the bank’s executives to manage the maturity and liquidity risks that are basic to the business of banking: they failed Money and Banking 101. There was the failure of market discipline by investors who either didn’t notice or didn’t care about the fact that the bank was severely undercapitalized for the better part of a year before it collapsed. There was the failure of the supervisors to compel the bank to manage the simplest and most obvious risks. And, there was the failure of the resolution authorities to act in mid-2022 when SVB’s true net worth had sunk far below the minimum threshold for “prompt corrective action.”

Waiting several quarters to act deepened the threat to the financial system, undermining confidence not only in many other banks but also in the competence of the supervisors. The extraordinary rescue actions last week by both the deposit insurer (FDIC) and the lender of last resort (Federal Reserve) are just a sign of the high costs associated with restoring financial stability when confidence plunges.

In this post we discuss each of these four failures, as well as the actions that authorities took to stabilize the financial system following the SVB failure. To anticipate our conclusions, we see an urgent need for officials to do at least five things:

  • First, to regain credibility, supervisors need to do an immediate review of the unrealized losses on the balance sheets of all 45 banks with assets in excess of $50 billion.

  • Second, they should perform a speedy and focused stress test on each of these banks to assess the  impact on their true net worth of a sizable further increase in interest rates. Any bank with a capital shortfall should be compelled either to issue new equity or shut down. (To ensure the availability of the necessary resources, authorities will need to have a pool of public funds available to recapitalize banks that cannot attract private investors.)

  • Third, to restore resilience, Congress must reverse the 2018-19 weakening of regulation that allowed medium-size banks to escape rigorous capital and liquidity requirements.

  • Fourth, the authorities must change accounting rules to ensure that reported capital more accurately reflects each bank’s true financial condition.

  • Finally, policymakers should assess the impact on the financial system and on the federal debt arising from the now-implicit promise to insure all deposits in a crisis. To limit risk taking, correspondingly greater fees and higher capital and liquidity requirements should accompany any explicit increase in the cap on deposit insurance.

Read More

Thoughts on Deposit Insurance

Government guarantees have become the norm in the financial system. According to the latest Federal Reserve Bank of Richmond (2017) estimate, the U.S. government’s safety net covers 60% of private financial liabilities in the United States. Serious underpricing of government guarantees gives intermediaries the incentive to take risk that can threaten the entire financial system: the Great Financial Crisis of 2007-09 is the most obvious case in point.

Deposit insurance is arguably the oldest and most widespread form of government guarantee in finance. In the United States, Congress established the Federal Deposit Insurance Corporation (FDIC) at the depth of the Great Depression in 1933 to help prevent bank runs. Today, more than 140 countries have some type of deposit insurance scheme.

In this post, we briefly review the evolution of FDIC deposit insurance pricing. We highlight evidence that, largely because of Congressional mandates, the federal insurance guarantee was underpriced for many years. It is not until 2011, following the crisis of 2007-09, that the FDIC introduced the current framework for risk-based deposit insurance fees, bringing insurance premia closer to what observers would deem to be actuarially fair.

Going forward, as with any insurance regime, keeping up with the evolution of bank (and broader financial system) risks will require a willingness to update the deposit insurance pricing framework from time to time. That means adjusting pricing to reflect both the range of bank risk-taking at a point in time and—to ensure the sustainability of the deposit insurance fund without taxpayer subsidies—the evolution of aggregate risk….

Read More
Mastodon