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A fix for the banking bust is coming into view

Former Treasury Secretary Steven Mnuchin said something surprising at the Milken Institute annual conference in Los Angeles on May 2, while discussing the regional banking crisis: “I think we need to raise the FDIC insurance. I’d raise it to $25 million.”

In Congress, Republican Sen. Marco Rubio of Florida is teaming with Democratic Rep. Ro Khanna of California on legislation that would established unlimited federal insurance for many bank accounts, according to Cornell Law School Professor Robert Hockett, who’s helping draft the legislation. That follows an FDIC report released May 1 that includes unlimited deposit insurance as one of three options for reforming the current system to prevent the type of bank runs that have taken down three regional banks during the last six weeks and are threatening others.

Republicans normally oppose government bailouts, and Democrats typically reject intervention that seems to favor the wealthy. But those battle lines are blurring as government and industry efforts to stanch a series of bank failures keep coming up short. Beginning with the collapse of Silicon Valley Bank in early March, the government has protected all deposits at failed banks, including uninsured deposits well above the $250,000 limit. That’s supposed to assure depositors all their money is safe, so they don’t withdraw money above the insured level and trigger a series of cascading bank runs.

It’s not working. A short period of calm set in after Silicon Valley and Signature banks failed in March. But panic returned as First Republic began listing, resulting in a government-brokered takeover by JPMorgan Chase on May 1. Several other midsized banks are now on death watch, including PacWest and Western Alliance, as depositors flee, share prices plunge and each bad turn reinforces the other.

BEVERLY HILLS, CALIFORNIA - MAY 02: (L-R) Elizabeth Burton, 77th US Secretary of Treasury Steven T. Mnuchin and Peter Orszag attend the 2023 Milken Institute Global Conference at The Beverly Hilton on May 02, 2023 in Beverly Hills, California. (Photo by Jerod Harris/Getty Images)
BEVERLY HILLS, CALIFORNIA - MAY 02: (L-R) Elizabeth Burton, 77th US Secretary of Treasury Steven T. Mnuchin and Peter Orszag attend the 2023 Milken Institute Global Conference at The Beverly Hilton on May 02, 2023 in Beverly Hills, California. (Photo by Jerod Harris/Getty Images)

Eleven of the biggest banks pumped $30 billion into First Republic on March 16, to demonstrate their confidence in the bank and the broader system. First Republic failed anyway. On May 1, the day First Republic failed, Citibank CEO Jane Fraser said at the Milken conference, “It’s good to have the last remaining source of uncertainty resolved today. The structure of the US financial system, it’s incredibly sound.” Markets didn’t believe Fraser. PacWest and Western Alliance shares plunged the very next day.

There are two basic factors causing these failures. The first is poor management of interest-rate risk generated by the rapid rise in short-term rates as the Federal Reserve tries to get inflation under control. Bonds issued at the much lower rates of a couple years ago lose value on the secondary market as present-day rates go higher. As rates rise, banks need to adjust their portfolios to account for the falling value of older bonds. The failed banks, to varying degrees, weren’t up to the job. There’s nothing the government can do about that.

The other problem is a historically high level of uninsured deposits at some of the floundering banks—and there is something the government can do about that. As banks get into trouble and start to report either real or potential losses due to interest-rate mismanagement, customers with less than $250,000 on deposit have nothing to worry about, because their money is insured, even if the bank fails. They can leave their money where it is knowing they won’t lose a penny.

Deposits above $250,000 are at risk, however, and that’s the money that’s been flooding out of troubled banks. As deposits flee, banks have to sell securities to cover the withdrawals. That locks in losses on securities the banks would have been able to redeem in full if they held them to maturity. Those losses fuel concern about the bank’s solvency. More deposits flee, shareholders sell, and the death spiral is on.

If deposit insurance were unlimited, there would be no uninsured depositors worried about losing their money. Banks could still mismanage risk, but there’s no reason it would trigger a run that makes the bank untenable. Most depositors would keep their money in, and troubled banks wouldn’t have to sell undervalued bonds at a loss. They might lose money and endure a stock selloff, but in theory they’d have way more breathing room to recapitalize and stay in business.

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The Rubio-Khanna legislation will reportedly call for unlimited deposit insurance for “transaction accounts” businesses use to pay their bills, but not for the personal accounts of wealthy individuals. “It would enable small businesses to make payroll without having to worry that only a quarter-million would be covered,” says Hockett. “Those types of accounts often have to have millions of dollars in them.”

There would be drawbacks. The government funds federal deposit insurance through assessments on banks, and more insurance would require higher assessments. Banks would probably try to pass that on to consumers through higher fees or lower rates on deposits.

There’s also the question of which banks would pay. There are three tiers of banks: small banks that serve local communities, bigger regional banks like those in the crosshairs now, and Goliaths such as Citi, JPMorgan, Bank of America and Wells Fargo. Many small-bank executives object to paying more for more insurance because they’re not the ones failing.

Big banks have a similar argument—plus the lobbying power to impose their viewpoints in Washington, D.C. “I’m all for raising the level of FDIC insurance premiums, but I would not go too far with it,” Wells Fargo CEO Charlie Scharf said at the Milken conference on May 2. “There’s no reason why the banks should subsidize the ills that happen at all of the banks across the system, unconditionally.” That’s a wordy way of saying mismanaged banks, and their depositors, should bear their own losses.

But there are risks of not expanding deposit insurance. Mnuchin, a Republican who served as Treasury Secretary under Donald Trump, argues that regional banks could disappear if the current crisis continues, leaving a huge funding gap for midsized businesses. “We have to fix this FDIC insurance issue because if we don’t, we’re going to end up without any regional banks. We’ll end up with community banks and big banks. I would encourage the politicians to figure this out soon.”

Only Congress can raise the level of FDIC deposit insurance, and that seems unlikely for now, given that Republicans who control the House are generally opposed to the idea. But if the regional banking crisis intensifies, that could change.

“Congress can act, but it is difficult to envision them acting unless we see more tangible market stress that crosses political, geographic, and ideological lines,” Isaac Boltanksy of BTIG wrote in a May 4 analysis. “While we have seen a number of high-profile bank failures, there has been a distinct sense among some in Washington that those were niche, coastal banks with limited footprints. If we see large regional banks with multi-state footprints across political geographies show signs of structural deposit flight, then lawmakers will mobilize quickly.”

Rick Newman is a senior columnist for Yahoo Finance. Follow him on Twitter at @rickjnewman

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