Bank failures highlight the importance of deposit insurance

Two high-profile bank collapses in the past two weeks have rocked the financial sector and left many savers looking for reassurance that their own deposits are safe. For most people, their bank or credit union balances are perfectly safe, subject to certain fairly high dollar limits beyond which they can easily remove additional risk.

It is helpful, and hopefully comforting, to recognize the individual factors that led to these dramatic failures and how little these institutions resembled the banks where most of us keep our checking and savings accounts. The collapse of Silicon Valley Bank in particular involved a combination of disastrous management decisions, a significant concentration of risky customers, and an apparent failure of regulatory oversight. It’s also a good time to rehearse how safe the US banking system remains for the average depositor.

Silicon Valley Bank, or SVB, was a California bank serving a concentrated and uniquely risky clientele: venture capital-funded startups. The bank quintupled deposits during the post-COVID-19 boom and both served as a lender to these fledgling ventures and held the significant capital provided to them by their investors. Many customers deposited millions of dollars with SVB, even though the accounts were only insured up to $250,000 and the rest was at risk in the event the bank became insolvent. At most commercial banks, most deposits fall within the FDIC limits. Nearly 90% of the deposits in SVB were uninsured.

That mistake was the depositors. What followed was a catastrophic failure of governance. Realizing that the deposits could be withdrawn at any time, the SVB nevertheless tried to make a profit by investing the deposits in long-maturity government bonds and mortgage-backed securities, literally betting the ranch that interest rates would stay low forever.

As the Fed embarked on its most aggressive rate-hiking cycle in history, the market value of the bank’s bonds fell. Meanwhile, venture capital flows have all but dried up, forcing startups to use their escrow accounts. To meet liquidity requirements, SVB had to dump $20 billion worth of bonds at flash sale prices while also announcing its intention to raise additional capital. Sensing danger, depositors demanded withdrawals just as the bank’s chief executive urged investors and customers to “keep calm and not panic”. It’s amazing banking slang for “get out of Dodge.”

The result was a bank run that forced California regulators to freeze assets and appoint the FDIC as receiver. Over the weekend, the FDIC, the Federal Reserve and the Treasury used their emergency powers to step in and help uninsured depositors using FDIC insurance funds. The Federal Reserve also created a special line of credit that allows banks to pledge their high-quality but discounted government bonds as collateral for short-term loans, buying time to raise new equity capital. The plan has been criticized for letting depositors off the hook for lax risk management, but SVB’s investors, including shareholders and some creditors, will be wiped out. Management was fired and the plan appears to have greatly mitigated the threat of contagion. The important thing is that taxpayers won’t be on the hook for the bailout.

It should be noted that the collapse of SVB and the closure of crypto-linked Signature Bank were dealt with expeditiously and their fatal wounds were largely self-inflicted and not representative of the traditional depository institutions holding CDs and checking accounts of most families.

Understanding FDIC Insurance

The Banking Act of 1933 created the Federal Deposit Insurance Corporation, which initially insured bank accounts up to $2,500. The limit has been increased over time, most recently to $250,000 by the Dodd-Frank Act of 2012. Most credit union deposits are similarly covered by the National Credit Union Administration.

The FDIC insures deposits up to $250,000 per bank for each person and for each different category of account ownership, so each person can be covered up to the limit in more than one account. For example, joint account holders are individually insured, so a husband and wife can own a joint account with $500,000 and be fully protected. Individual accounts, trust accounts and certain retirement accounts are also treated separately, with the $250,000 limit applying to each category. Pay-on-death (POD) accounts are a type of trust account where the limit applies separately to each named beneficiary.

Balances in excess of the FDIC’s total limits may be insured by spreading across multiple banks. Also, many institutions belong to an interbank network that allows your home bank to hold CDs or accounts in your name at other member banks while maintaining a contact and reporting relationship with you.

Businesses that may need cash balances higher than the insurance limit often use treasury services that can handle day-to-day cash management for a small fee. It is also relatively easy to buy short-term US Treasuries in the highly liquid secondary market with next-day settlement. US Treasury securities are not technically insured by the FDIC, but are backed by the full faith and credit of the US government.

The Fed and FDIC’s aggressive response to the SVB failure was not without its critics, but it appears to have contained the risk of a wider deposit build-up. A review of the failures that led to the collapse is already underway and is likely to lead to increased supervision for riskier institutions. Meanwhile, for the rest of us, the banking system remains safe and secure.

Christopher A. Hopkins, CFA, is the co-founder of Apogee Wealth Partners.

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