Inside the legal loophole US regulators used to bail out SVB depositors
When the Biden Administration announced on Sunday that customers of collapsed Silicon Valley Bank and Signature Bank would receive a full return of their lost deposits, it tapped a single exception to banking law that otherwise caps protection for cash and cash equivalent deposits at $250,000.
The exception, known as the Systematic Risk Exemption (SRE), is a caveat in the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA), a law that requires that the Federal Deposit Insurance Corporation (FDIC) impose the “least cost” on taxpayers when it uses its Deposit Insurance Fund (DIF) to wind down failed banks.
The law — which limits the FDIC's power to guarantee deposits — emphasizes that the agency must choose the least costly method, even if doing so inflicts losses on a failed bank's uninsured depositors, creditors, and shareholders. In theory, the statute incentivizes government officials to pay out no more than the act requires.
However, the exception, invoked four times in response to the 2008 financial crisis and pared down under the Dodd-Frank Act, can extend reimbursement to uninsured deposits when the U.S. Treasury Secretary decides that the additional FDIC assistance would lessen “serious adverse effects” to economic conditions or financial stability, otherwise bound to happen under the “least cost” response. To use that authority, the Secretary must first obtain authorizing votes from two-thirds of the FDIC’s board and two-thirds of the Federal Reserve’s Board of Governors, plus consult with the president.
In a press briefing Monday, following a weekend filled with concerns over contagion risk, President Biden said taxpayers would be spared the cost of backstopping uninsured deposits, while shareholders and certain unsecured debt holders would not see their losses reimbursed.
“No losses will be borne by the taxpayers,” the president told reporters. “Instead the money will come from the fees the banks pay into the Deposit Insurance Fund (DIF).”
'I'd consider that a bailout'
Still, the decision to fully reimburse uninsured depositors has sparked controversy from critics who see the measure as an unfair use of banking law, and ultimately, as a government bailout.
Ken Griffin, founder of behemoth hedge fund, Citadel, reportedly described the decision to the Financial Times as a bailout that evidences a breakdown of American capitalism.
Vanderbilt University Law School professor Morgan Ricks said while "bailout" isn't a legal term, reasonable minds can disagree about the administration's interpretation of the law's gray area.
"We have uninsured depositors being made whole. I'd consider that a bailout," Ricks said. "Also people can reasonably say this is not a bailout."
Morgan noted that this week's measures differ significantly from the controversial backstops that taxpayers were asked to shoulder in the 2008 financial crisis, when FDIC funds alone proved too minimal to cover SREs that the Bush administration authorized to rescue some of the nation's largest banks.
The rescue package then sourced hundreds of billions of dollars from the Treasury, the FDIC, and the Federal Reserve Bank of New York to absolve Bank of America, Citigroup, and Wachovia of financial responsibility for failed mortgages and other loans. Unlike stricter requirements in today's banking law that make FDIC funds inaccessible to going concerns, Bank of America and Citigroup were permitted to remain in business, while the SRE paved the way for Citigroup's acquisition of Wachovia.
Nationwide deposit guarantees for regulated banks can be traced back to 1933 when widespread bank closures and resulting deposit losses fueled Congress to create the FDIC. Its stated goal at the time was much the same as it is today: to pay depositors up to the insurance limit in the event the bank fails, sell the bank’s assets, and settle its debts.
While the DIF — the fund that pays out depositor losses — is primarily funded through quarterly assessments on insured banks and, to a lesser extent, through interest earned on investments and assets recovered through liquidations, critics say that because the fund is ultimately backed by the full faith and credit of the federal government, taxpayers are taking on risk when the government chooses to make uninsured depositors whole. The FDIC is also authorized to tap a federal line of credit if DIF funds fall short.
According to Ricks, taxpayers would be on the hook only if the FDIC became insolvent, which happened following the 1980s savings and loan crisis that cost taxpayers around $125 billion and gave rise to the FDICIA.
One former FDIC director who asked not to be identified told Yahoo Finance that the risk to taxpayers in insuring Silicon Valley Bank and Signature Bank customers is remote because the FDIC is nowhere near a need to access the FDIC's line of credit.
For the fourth quarter of 2022, the DIF reported a $2.8 billion increase in its balance sheet to $128.2 billion. Assessments for the period totaled $2.1 billion and accounted for the fund’s largest source of revenue, followed by fund investments that totaled $498 million.
Yet Ricks points out that banks can be expected to pass increased assessments to their customers and shareholders, many of whom are U.S. taxpayers.
"We shouldn't pretend that that is somehow not affecting the American people. It does, indirectly," Ricks said. "It's impossible to say what the ultimate incidence of those costs are, but the costs are real."
'That's how capitalism works'
Also up for debate is whether or not the administration's use of the legal exception further exposes taxpayers by setting a new standard for bank deposit insurance.
"This sets a precedent," Ricks said. "And it becomes hard to argue that depositors in large banks are really bearing the risk of bank failure that the law says they are."
In 2010, a study by the nonpartisan Government Accountability Office concluded that the more flexible law in place during the 2008 financial crisis would weaken incentive to manage risk. Several months after the study, Congress revised SRE so that it could be utilized only in the event that the subject bank is shuttered.
In his Monday press briefing explaining that loss coverage would not extend to investors, President Biden said.
“They knowingly took a risk and, when the risk didn’t pay off, investors lose their money," he said. "That’s how capitalism works.”
Alexis Keenan is a legal reporter for Yahoo Finance. Follow Alexis on Twitter @alexiskweed.
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