15 March 2023 Equities

SVB Follow-Up: There Was Little Reason to Worry About Uninsured Depositors

Summary

The suspense last weekend around the Silicon Valley Bank and Silvergate Capital failures revolved around the fate of uninsured depositors.
We need not have worried. Regulators have broad authority to suspend insurance limits and virtually always do when banks fail.
Given this history and the specific circumstances of SVB and Silvergate, it would have been an extraordinary departure for regulators to leave uninsured depositors in the lurch – and one fraught with political risk if they had.

Market Implications

Despite widespread expectations, there is little likelihood that full insurance coverage will be extended to all deposits.
Then again, in most cases full coverage will be available when the need arises.

FDIC Has Broad Authority to Suspend Deposit Insurance Limits

The big source of suspense last weekend was what would happen to uninsured depositors at Silicon Valley Bank. There were dire reports of countless startups being unable to make payroll and having to shutter operations.

Then the Fed and the FDIC came through. All deposits would be guaranteed and available on Monday morning, 13 March.

It was something of a shockwave. Respected commentators said the FDIC now had no choice but to guarantee all deposits going forward. We wondered about the implications of effectively nationalizing the banking system. Others issued dark warnings about moral hazard and eliminating any calculation of risk in banking.

Here is what no one seems to know. When banks fail, the FDIC virtually always covers uninsured depositors.

Digging back in history, before the Penn Square bankruptcy in 1982, the FDIC covered uninsured depositors. This was generally accomplished through selling the failed bank to the healthy bank, where the buyer took on all the deposits and the FDIC quietly made up the difference between the value of uninsured deposits and face value.

In the Penn Square debacle, the uninsured deposit base was so egregiously noneconomic that potential buyers refused to take them on. That was very much an outlier.

The next big case where uninsured depositors where not made whole was the IndyMac Bank in July 2008. The political blowback from that decision meant the FDIC has since rarely saddled uninsured depositors with losses. Of some 540 failures since IndyMac, nearly 95% were resolved without losses to uninsured depositors.

Why Uninsured Depositors Get Covered

The FDIC rarely imposes losses on uninsured depositors for various reasons.

It usually deems the sale of a failed institution with full coverage to be the least costly approach to resolving the situation.
It has broad authority to temporarily suspend deposit insurance limits in cases where uninsured deposits are to be used for payroll purposes or business working capital.
The FDIC, Fed and Treasury have authority to temporarily suspend deposit limits if a bank failure could pose systemic risks to the banking system.
There are public policy considerations such as the impact on small communities if a local bank is closed and people cannot access banking services.

The SVB and Signature Bank situations were unusual in that they did not involve selling the failed institutions. We will probably never know exactly why regulators stepped into cover insured depositors but news stories make it clear that it was some combination of the second and third reasons above.

Blanket Deposit Coverage Not in the Cards

There are two key points here.

First, based on FDIC history, it would have been extraordinary had regulators not moved to cover uninsured depositors. Leaving aside economic implications for forcing an entire generation of startups out of business in one fell swoop, the political blowback from Congress and state legislatures would have been immense.

Second, covering uninsured depositors when banks fail is standard operating procedure. There is no need – and de minimis likelihood – that a blanket deposit guarantee will be established soon.

We do not mean to be cavalier about the risks that these situations pose. It is always possible that some cowboy regulator takes the “high road” and imposes losses on uninsured depositors, whatever the public policy or economic implications might be. Look no further than Hank Paulson letting Lehman Brothers collapse in 2008 without regard to the likely consequences.

While the high probability likelihood is that uninsured depositors will be covered in the event of bank failures, investors need to carefully examine the facts and circumstances (and personalities) when these events happen.