Pub. 11 2023 Issue 2

Putting idle deposits to work — it’s what makes the U.S. economy the envy of the world. For decades, America’s banks have successfully leveraged the idle deposits of businesses and individuals to fuel unprecedented economic growth, lift families out of poverty and raise everyone’s standard of living.

Fractional reserve banking is a powerful tool at the center of true wealth creation, yet few people really understand how it works. As we debate policy changes in the wake of the Silicon Valley Bank collapse, it is vital that we preserve this important tool and, ideally, enhance it.

How do bankers put idle money to work yet ensure that it is always there when a depositor needs it? The answer is a combination of prudence, discipline and confidence. And a big driver of that confidence is deposit insurance.

The whole process is built on trust. It requires experienced bankers who can properly evaluate creditworthiness, borrowers who are determined to pay their loans, depositors who are not prone to panic and a financial system that provides transparency and can move money quickly and reliably.

The 2008 financial crisis was driven by poor lending and delinquent borrowers and resulted in massive changes to lending rules. The recent financial scare was driven by mismanaged liquidity and panicked depositors and is driving a debate about the foundation of our fractional reserve banking system — deposits. It’s critical that we get these policies right.

At the center of this debate is how we insure deposits at banks. Currently, we guarantee deposits up to $250,000. Every bank pays into an insurance pool (FDIC), and if any bank fails, the depositors are made whole, up to $250,000, out of this fund. To ensure complete confidence in this fund, it has the backing of the U.S. Treasury, but taxpayers have never had to step in.

That $250,000 of insurance covers most idle deposits in the U.S., but there is a significant pool of deposits above that threshold — held by a relatively small number of depositors — that remains uninsured. These deposits are at the center of the current debate.

Many view deposit insurance as a benefit provided to depositors and question why we should provide that benefit to wealthy individuals or large businesses. While others trumpet the overall economic benefits of our fractional reserve banking system and the benefits to all Americans of leveraging every available deposit.

Limiting benefits to the wealthy and large businesses makes for good political soundbites, but in this case, it limits economic growth and creates a significant amount of uncertainty. And the fact of the matter is that government agencies have already taken action to address these uncertainties, which “effectively” insure most of these uninsured deposits.

The most widely acknowledged type of action is often referred to as “too big to fail.” This applies to the largest banks, whose failures would cause broader, systemic threats to the economy. This has repeatedly resulted in regulatory action that most perceive to “effectively” extend the basic deposit insurance system. Without much debate or legislative action, this was dramatically expanded during the recent financial scare to include banks that most would not have previously thought to be systemically significant.

The less widely acknowledged type of action refers to FDIC resolution policies that effectively establish a standard that could be called “too small to tolerate depositor losses.” For the last 10 years, nearly every time the FDIC closed a smaller bank, they sold the bank to a stronger bank with the requirement that they assume ALL deposits (even those over $250,000). The cost of “effectively” insuring all deposits at these smaller banks also came out of the insurance fund. While this worked well, it basically saddled the industry with the costs of insuring all deposits without any of the market benefits.

The combination of these approaches to large and small banks is likely the source of all the angst we are hearing involving “mid-sized” banks — an ambiguous group that might be too big to fit into one category but too small to fit into the other. Frankly, no one really knows who they are for sure. But by allowing policies to form piecemeal, we have created enormous ambiguity and distorted the flow of deposits in America. Agencies are effectively picking winners and losers, and that is simply not right.

In the face of that ambiguity, some banks have turned to a market-based solution to expanding deposit insurance by breaking up larger, uninsured deposits into $250,000 fully insured pieces and exchanging them with uninsured deposits at other banks. This reciprocal deposit market innovation has seen a dramatic uptick since the Silicon Valley Bank collapse and will only continue to grow.

In the end, uninsured depositors are going to figure out a way to get fully insured through market innovation or “effectively” insured by exploiting regulatory preferences. Thanks to our fractional reserve banking system, this trend to securely deploy more deposits into the U.S. economy will benefit every American. But the goal for the industry must be to adopt an official policy that ensures that all banks have equal access to those deposits.

As we engage in this debate, it will benefit everyone if we rise above the class warfare that can result from viewing deposit insurance as a benefit to depositors and focus on the broader benefits of our fractional reserve banking system to all Americans.