The great deposit migration, moral hazard and a fragmented banking system

REAL ECONOMY BLOG | March 27, 2023

Authored by RSM US LLP

Fragmented and fragile are appropriate words to describe the American banking system.

The recent financial shock has exposed the underlying problem: A flawed regulatory framework treats small and medium-size institutions unequally compared to their largest competitors.

The current deposit insurance limit of $250,000 per account is a pleasant fiction that has been unmasked by both the run on several regional banks and the steps taken by the Federal Reserve and Treasury to stop that run.

Policymakers need to address ways to expand deposit insurance as soon as possible to prevent a wider crisis.

One result of this bank run has been a migration of deposits from community and regional banks to the nation’s largest financial institutions—the deposit carousel.

This migration happened because deposits at systemically important financial institutions have the implicit backing of the federal government—recall the financial crisis—and those at the regional and community banks do not.

In our estimation, this puts at risk the deposits of millions of U.S. households and the small and medium-size firms that employ them.

Concerns of moral hazard that would be raised with the expansion of deposit insurance deserve further consideration, as does its cost.

But the structural changes in the economy over the past two decades have outrun the regulatory framework that was stitched together after the Great Financial Crisis. The status quo is untenable for small and midsize banks.

The current $250,000 insurance limit simply does not reflect the reality that small and medium-size firms hold deposits well in excess of that limit.

It is far past time for the regulatory framework to be updated to reflect that reality. An explicit guarantee of deposits for both U.S. households and the firms that support them will need to be put in place for the current banking crisis to be brought to an end.

The deposit carousel

The Federal Reserve reported that while deposits held by large domestically chartered banks grew by nearly $120 billion during the week ending March 15, small domestic banks lost just under $108 billion.

The migration of cash into money market funds is even more stark. In late March, there was about $5.13 trillion sitting in such accounts, which is up by $238.9 billion since the start of the crisis. The winners of this capital migration have been JPMorgan and Fidelity, according to The Financial Times.

While this is small given the $17.6 trillion in total deposits in the American banking system, it still has had a significant effect. As of March 15, large banks had $10.8 trillion in deposits while smaller institutions had $5.5 trillion.

The great migration of deposits could very well accelerate as a loss of confidence in deposit insurance inside a fragmented banking system intensifies.

Questions of moral hazard should not interfere with addressing the status of deposits made by households, and small and medium-sized firms.

Banks have been slowly losing deposits, often to money market funds, throughout the year, and this is first week of gains for large banks after six consecutive weeks of outflows.

In percentage terms, the deposits from large banks were dropping at an average annualized rate of 3% through March 15. Compare that to the 27% average annual rate of decline at small banks.

Withdrawals at foreign-related banks dropped at a 25% average annualized pace over that same time period.

In total, bank deposits fell by $53 billion, reflecting the move to money market funds or other investments.

This captures the deposit carousel only through the first week of the crisis. It is probable that as the crisis moved into its second week, the flows of capital into areas of the financial market that are considered safe or obtain a greater yield will remain elevated.

The lessons of past crises

Before the Federal Reserve was created in 1913, the American economy had suffered from a series of economic booms and sharp recessions brought on by panics and bank failures.

In 1907, J.P. Morgan, the person who created U.S. Steel and General Electric, organized a collection of financiers who created a financial backstop that would pump money into failing banks and purchase the stock of healthy companies that were under attack.

It has taken a hundred years of trial and error for central banks to develop their skills. For example, the economist Thomas Piketty—and long before him, Milton Friedman and Anna Schwartz—made the case that the refusal of global central banks to create the liquidity needed to save troubled banks in the 1930s resulted in a wave of bankruptcies and the Great Depression.

The crux of the debate about central bank independence and the role of lender of last resort can be summed up by the catastrophes of the Great Depression and financial crisis, and the divergent set of policy responses by the central bank. One resulted in a depression and one did not.

Following those financial breakdowns, there is a general agreement that the principal function of a central bank is to ensure financial stability.

Central banks are the lenders of last resort. That has been on vivid display recently, and also during the freeze-up of the money markets in the early stages of the pandemic in 2020.

The common thread that runs through economic thought is that central banks need to operate independently and do whatever is necessary to avoid financial and economic collapse.

While questions around moral hazard are germane to the lender of last resort question, they are more applicable to the design of policy following a crisis as opposed to policy decisions made during one.

Now, we are suffering through another series of bank failures, which were set off by the mismanagement of bank balance sheets as interest rates rose over the past year. Those higher interest rates also led to the bursting of bubbles in the cryptocurrency and technology sectors.

To the best of our knowledge, the affected banks ignored the interest-rate risk of investments in long-maturity bonds whose sale value dropped as interest rates rose. These rate increases were hardly a surprise: The Fed publicly stated its intentions to increase its policy rate until demand dropped enough to tame inflation.

So why should taxpayers have to bail out these institutions? Wouldn’t another bailout create the incentive for banks to take reckless positions in the markets or in their lending practices?

Arguments against bailouts

There are at least two reasonable arguments against bailing out U.S. banks.

The first is that the banks in this current episode are relatively inconsequential and by themselves did not pose a systemic threat to the financial system. Given more time, they could have solved their liquidity problems with infusions of cash by would-be investors before holding an orderly sale of assets.

Yet letting the banks fail would surely have precipitated a broader run on other banks, and, ultimately, a financial crisis that would affect not only high finance but also the heart of the American real economy.

We would point to a paper by the Nobel Laureates Douglas W. Diamond and Philip H. Dybvig, which argues that a bank failure can precipitate a loss of confidence among all depositors, resulting in a bank run.

They argue that banks have a distinct role in the economy: the transformation of illiquid assets into liquid liabilities. While uninsured demand deposit contracts can provide liquidity that fosters economic growth, the presence of those uninsured deposits leaves banks vulnerable to runs.

In our evaluation, protecting the public and the economy from bank runs assigns banks the role of a quasi-public utility. That is, a private enterprise able to reward its owners for its efficiency and acumen, while protecting the economy from the public cost of a bank run and economic collapse.

The second argument is that bailouts and the guarantee of deposit insurance foster the moral hazard of irresponsibility of bank and depositor. This is the “let the markets prevail” argument noted by Martin Wolf in The Financial Times.

In the extreme, it would assign due diligence to every depositor and assign losses to bank management, shareholders and holders of bank debt.

Most important, it would assign losses to depositors who have neither the ability nor the time to analyze their bank’s balance sheet.

As we pointed out, the laissez-faire era of earlier economic systems is simply not efficient or realistic.

What’s to be done?

We would argue for a public-good model for the banking industry. That would require additional regulation for banks no matter their size, and realistic and universal stress tests that assess a balance sheet’s exposure to interest rate risk and recession.

This all is underscored by a near-term policy decision that needs to be made around an explicit deposit guarantee. While we recognize that questions of risk premia and risk characteristics of different banks need to be included in any viable framework, the question of the degree to which deposits are guaranteed cannot be avoided.

The irony of the failure of the regional banks is that if they had not lobbied for reduced regulation, a mandatory stress test might have saved them from failure and saved the public from the expense of a bailout, even if those costs take the form of higher fees on the banks that do survive.

The Fed was explicit in the direction that interest rates would take. In the end, the public will be responsible for the cost of recouping those losses and the transformation of the domestic banking system.