The regional banking crisis of 2023 and its aftermath have hastened the need for deposit insurance coverage to be optimally designed, according to a paper by Yale University economics professor Eduardo Davila and Wharton finance and economics professor Itay Goldstein. Their paper, “Optimal Deposit Insurance,” provides a framework for weighing the tradeoff regulators will face in determining the coverage limits: While increasing coverage can help reduce the probability of bank failures, it could also embolden banks to engage in riskier behavior and thereby increase costs when banks fail.

The 2023 banking crisis, headlined by the collapse of Silicon Valley Bank, exposed the challenges banks face with their large and growing share of uninsured deposits. Uninsured depositors could trigger runs on banks when they perceive unmanageable risks, the paper noted. The paper was discussed at a recent conference co-hosted by the Wharton Initiative on Financial Policy and Regulation (WIFPR) with Yale’s Tobin Center for Economic Policy.

Goldstein and Davila provide a framework to determine the optimal level of deposit insurance to stave off bank runs. The framework allows ways to measure the welfare impact of changes in deposit insurance coverage limits, and the costs it will entail. The authors demonstrate the efficacy of the framework by applying it to the 2008 financial crisis. As it happens, that crisis triggered the most recent change in deposit insurance to $250,000 per account; the previous limit had been $100,000, since 1980.

“The deposit insurance limit is updated every once in a while, but not very rigorously or not with much data or science behind it,” Goldstein said. “What we wanted to ask is, can we have a framework that will guide policymakers on what that limit should be?”

The pros and cons of deposit insurance

Optimal deposit insurance limit would essentially have to be “socially optimal” in a way that maximizes the welfare or utility among economic agents or people, Goldstein continued. “It entails a cost-benefit analysis to see whether the benefit of changing the limit is significant enough relative to the cost.”

The benefits are clearly in helping create a more stable banking environment. “When you have more deposit insurance, it reduces the probability of a run and a bank failure,” Goldstein said. “Depositors might run on a bank when they think that their money is at risk. But if you insure them, their money is not at risk.” Governments will typically meet the costs of providing that insurance through taxation.

The paper noted that after the introduction of the federal deposit insurance in 1934 (with a limit of $2,500 per account), the number of bank failures dramatically reduced. More than 13,000 US banks failed between 1921 and 1933 in the midst of the Great Depression, but only 4,057 banks failed between 1934 and 2014.

While deposit insurance helps reduce bank failures, it involves a moral hazard, where market participants could, for instance, go lax in running the banking system. That possibility underscores the need to design optimal levels of deposit insurance coverage.

Designing the deposit insurance framework

The framework in the paper incorporates the tradeoffs that policymakers would have to consider in determining the optimal deposit insurance limit. It visualizes an environment with uncertainty about the profitability of banks’ investments, where both fundamental-based and panic-based failures are possible. It then mimics deposit insurance arrangements and weighs the implications for social welfare with varying degrees of coverage.

Essentially, the tradeoffs boil down to two possible scenarios: On the one hand, a marginal change in deposit insurance coverage may substantially reduce the likelihood of bank failure with significant gains from avoiding that failure. In such a situation, it is optimal to increase the level of coverage, the paper stated. On the other hand, when bank failures are frequent and when the social cost of subsequent interventions is high, the optimal route would be to decrease the level of coverage, it added. It might be unwise to incur the social cost of intervention, for instance, when it is very costly to raise resources through distortionary taxation, the authors wrote.

Goldstein said the framework incorporates four ingredients: One is the likelihood of a bank failure. The second is the cost of funds for the government to provide deposit insurance. The third is the relationship between the benefit from deposit insurance and the probability of a crisis, such as bank run. The fourth is the likely damage from a run.

Determining the right insurance coverage

When the authors applied their framework to the change in the deposit insurance limit in early 2008, they came up with an optimal level of coverage of $381,000 per account. That is substantially higher than the decision back then to raise the coverage limit to $250,000 in October 2008. Even so, the welfare gains are “very large” from increasing the coverage from the earlier limit of $100,000, they stated in their paper. They also qualify their choice of $381,000 as the coverage limit by noting that it is “perhaps more aligned with the extended guarantees that were implemented soon after” the 2008 financial crisis.

Incidentally, in March 2023, after Silicon Valley Bank and Signature Bank collapsed, the Treasury, the Federal Reserve and the FDIC extended to them a “systemic risk exception,” where it made whole all of the bank’s depositors. Taxpayers will not bear the losses from the two banks, they announced in their joint statement.

That one-time exception was widely seen as an attempt to prevent a contagion effect where depositors across the banking industry might feel vulnerable. Silicon Valley Bank’s assets were eventually moved to a bridge bank the FDIC set up, and New York Community Bancorp took over select parts of Signature Bank. The episode prodded policymakers and regulators into exploring ways to strengthen the banking system from bank failures.

Pointers for bank regulators

Goldstein recalled that after the 2023 crisis, many policymakers and legal scholars called for unlimited deposit insurance. “Our paper exactly goes against that. There is a benefit. There is a cost. You want to find the optimal balance between the cost and the benefit.”

Goldstein said that while it would be prudent to revisit deposit insurance limits from time to time, it would be unwise to change it too often. “It would be good to have a dynamic adjustment of the deposit insurance limit, but it might be infeasible because you can’t readjust it every month.”

Their paper also looks at how emerging economies should set their insured limits. In most European countries, the current deposit insurance coverage limit is 100,000 euros ($108,000 at the current exchange rate).

Goldstein and Davila do not, of course, provide a fail-safe way to prevent bank failures, but stated that their analysis provides the tools to build a “theory of measurement for financial regulation that can be applied to a wide variety of environments.” The ability to measure aspects such as “the sensitivity of bank failures to changes in the level of coverage and the relevant fiscal externalities associated with such a policy change” can potentially guide regulators, they added.

Goldstein said that their framework may end up capturing too many moving pieces that may be seen as “noisy,” but argued that it is still a step forward. “It’s better to have a noisy framework than have no framework at all. The way that this policy has been set over the years was very arbitrary.”

Deposit insurance helps minimize or prevent bank runs, but it must be accompanied by other actions to strengthen the banking system, Goldstein said. Among his suggestions: increased scrutiny of mid-sized banks, more imaginative stress tests and more effective capital and liquidity regulation.

In the first quarter of 2024, the US banking industry showed growth in net income, along with favorable asset quality, according to an FDIC report. But it continues to face “significant downside risks” from inflation, interest rates and geopolitical uncertainty, it noted. It specifically mentioned a deterioration in certain loan portfolios such as commercial real estate and credit cards.

[Knowledge at Wharton first published this piece.]
[Lee Thompson-Kolar edited this piece.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.