Deposit insurance under the coverage

Patrick McKenzie (patio11)

When we discussed deposits as a financial product I handwaved away explanation of an important bit of financial technology which makes them work, deposit insurance schemes. Along with the broader constellation of bank regulation, they form the public part of the public/private partnership that makes deposits money-good and therefore undergirds every transaction in the banking system and most of the wider economy.

This issue will be more U.S.-centric than I like, mostly because I understand the Federal Deposit Insurance Corporation, which runs the U.S. deposit insurance scheme, far better than any similar government agency. In broad outlines, I’d expect Japan, the UK, European Union countries, and similar to have similar mechanics, but can’t opine intelligently on them without doing more reading.

I'm going to talk fairly confidently about the fintech industry in a moment, and will repeat my usual disclaimer that I work at Stripe. Opinions in this space are mine alone and were not e.g. run past a lawyer for an accuracy check.

The covered peril

Every insurance policy has a notion of “covered perils”: it will pay out if and only if an event matching a limited description happens. Deposit insurance covers precisely one covered peril: the loss to depositors (1) caused by the failure (2) of an insured financial institution (3).

From this you can deduce a lot of things which are not covered perils:

Did you lose money on a bank-issued bond or equity? Not covered; your higher rate of return was specifically to compensate you for the risk you were taking. As we covered previously, your money protected depositors. Thank you for your service.

Did your bank eff up a given transaction with you, in such a way that you lost money but the bank is still open for business? Not covered; your recourse is with the bank, its regulators, or the legal system.

Did a business which has an account at an FDIC-insured institution, but is not itself an FDIC-insured institution, fail? Not covered. If their bank is still open for business, your princess is in another castle, and you’ll very likely have to follow a bankruptcy proceeding with interest.

This last one is a bit of a sticking point for financial technology firms, which experience a dilemma in building products which mimic some features of deposits. On the one hand, they want to message those products to the market as secure. On the other hand, they typically need to keep customers money in the banking system, generally at an FDIC-insured institution.

But they are not themselves FDIC-insured institutions.

A thing which some app marketing teams will say is that deposits are secure up to applicable limits, which may mollify customers but may not answer the question they truly have. The thing which is often mumbled in these situations is that customers’ money is insured against the failure of the underlying bank, whose risk of failure is known to be very remote, but not insured against the failure of the technology platform, whose risk of failure is almost always orders of magnitude larger than that of the bank.

This is a heavily facts-and-circumstances-dependent detail, and even fintech product teams and lawyers often fail to understand the nuanced difference in mechanics between various implementation options for deposit-adjacent products when exposed to various tail risk events. Regardless of those differences, which could fill volumes and occupy many billable bankruptcy attorney hours, you can round this to “The FDIC does not insure against the primary sources of risk to users of fintech products.”

Anatomy of a bank failure

But let’s talk about what deposit insurance does do. Bank failures are auto-catalyzing processes, similar to meltdowns of nuclear reactors. Deposit insurance is designed to make failures less likely and limit damage caused by them, through a variety of technical means. You could analogize it to some combination of monitoring staff, control rods (and technical measures for deploying them), and cleanup crew.

Most bank failures happen slowly and then quickly. Most banking crises happen sporadically along the periphery of the banking system and then suddenly everywhere all at once. Deposit insurance is designed to limit and contain the damage on the individual bank level to minimize the chance of failures cascading in a systemic fashion. (Making depositors whole is both a necessary prerequisite of this and, to a degree, a happy side effect of this core function.)

The thing which happens slowly to banks is making bad loans. This takes a substantial amount of work, generally spanning many people’s efforts over years. Lots of smart people have to go into work every day, produce a lot of paper, and bend all of their professional efforts to the task for a bank end up with a pile of bad loans.

This sounds like a joke but it isn't one. A good portion of banking regulation is making it hard to do things that blow up banks. That is why banks don't routinely have e.g. 25% of their loan book concentrated in loans to single overleveraged hedge funds, a pattern that the crypto industry has recently discovered the riskiness of.

Recall that deposits are liabilities which allowed a bank to leverage up their capital to purchase or manufacture assets, which will overwhelmingly be loans. Many things can make a loan bad. The most obvious one to non-specialists is abysmally poor credit quality; a loan which was doomed to never be repaid is, obviously, a bad loan. Very few loans are bad in this fashion.

The more likely failures of underwriting loans are pricing credit quality poorly (not earning enough interest to cover the risks associated with a loan) and poor portfolio construction.

The first was a major contributing cause to the global financial crisis; for complicated reasons, the United States via a combination of policy and market forces ended up in a situation where the financial industry greatly mispriced risks in so-called subprime home loans and overproduced them relative to true market demand for those assets and, relatedly, for the homes. (Most discourses about the financial crisis miss that the malinvestment is not just in improper operation of a spreadsheet but in bending the productive resources of the nation to build particular physical instantiations of homes, using bricks and concrete and labor and similar, in particular places, such that no buyer actually existed for the home near the price the home was believed to command.)

Anyhow, back to failing banks. Suppose you’ve made some bad loans, a process which took you years. Suppose you’ve actually lost money on some of these loans, which is not co-extensive with making a bad loan; you can lose money on good loans (and frequently will!) and you can have bad loans which are, for the moment, paying as agreed.

You can, through either ill will or desire to provide your valued customers with the experience that keeps bringing them back, paper over those losses by e.g. lending commercial real estate operators more money for new projects, with them using some of it to make payments on their old loans. This is one of the dangerous auto-catalyzing processes for bank failure: the hole is getting deeper by a mechanism which prevents you from seeing there is any hole.

In principle, bad loans are enough to cause a bank failure. In practice, there is almost always a catalyst and that catalyst is almost always a liquidity crunch.

Keeping your bank hydrated

Banks need to be liquid—to have assets which can be easily converted into money at very close to the value they are marked as having—for day to day operations. Partly this is to e.g. make payroll and pay vendors, but overwhelmingly it is necessary to service depositors.

Predicting depositors’ demands for liquidity is one of the core boring challenges of banking. It isn’t anything close to constant over time; it tends to surge around payday, for example, and holidays, and during periods of broad financial stress. (Somewhat counterintuitively, banks often become more liquid during crises, as e.g. depositors sell financial assets and move cash into the bank, or as e.g. a community bank which recently saw its community hit by wildfires sees insurance payouts move billions of dollars of settlements into the bank one account at a time.)

What happens when a bank is not as liquid as it predicts it needs to be? It sells assets, and generally the best assets go first. A bank with marketable Treasury securities (debts of the U.S. government), for example, can find a willing buyer for them with virtually no slippage at basically any time. A bank might have some bonds of publicly traded companies, and perhaps it would take more of a loss selling those, but in most market conditions those sales can be done quickly.

Run out of things which you can push a button to sell? Well, you still have options. You’ll look at your loan book, and start with e.g. high-quality residential mortgages which are conforming. There is almost always a buyer for that product, and it can be done relatively efficiently, but not as efficiently as Treasuries or marketable securities.

Then you’ll start looking at your non-conforming mortgages and commercial loan book. And around here is where you start to run into trouble.

See, your bank is heavily entwined in the microeconomy it operates in, as are all of your counterparties. (If your bank is under stress, it is overwhelmingly likely to be a community bank. That said, this generalizes to basically all sizes of banks.)

Your loan books are likely to be very correlated. Basically every effective process to grow loans introduces more correlation. You site your branches in places where you think they will get attractive business brought to them, and your loan book starts to concentrate in those neighborhoods. You hire loan officers who are good at getting deals done, and your loan book concentrates in the professional networks of those loan officers, of whom you probably have less than a few dozen. You provide excellent service to your customers and they refer their friends, and their friends tend to be from the same industry with the same rough credit profiles doing business in the same areas.

When you attempt to sell concentrated packages of risk, the buyer, who is likewise a savvy financial institution, will do two things.

One, they will want a discount to what you think the package is worth, both to make it worth their while to absorb the friction of the deal and also to compensate them for correlated risk.

Two, they will blab to everyone they know that you are shopping blocks of your book.

In particular, many of your loans are to commercial real estate developers and operators. Here it is useful to understand that CRE professionals are the most indiscrete industry on God’s green earth. The industry runs on secrets and alcohol, and both are exchanged to lubricate relationships. Some enterprising bartender should mix a cocktail and brand it Non-Disclosure Agreement; it would sell swimming pools.

Commercial real estate players are local rich people and pillar members of the community. Birds of a feather flock together, and CRE players talk to people much like themselves, at the bar, on the golf course, at church, at barbecues, etc. It is literally their business to talk to most of your deposit base.

And the thing they say will be that your institution is undergoing stress, and that the first people to withdrawal their deposits will get 100% of their money, but that later depositors attempting to withdraw might not.

And then you end up with a bank run, the most dangerous auto-catalyzing part of bank failures, where your depositors race to get their money out.

In most cases, if you’re killed by a bank run, the damage was done long before. You earned your fate via years of diligent work making bad loans, and became insolvent. The bank run revealed the insolvency.

Failing bankers often don’t agree with this. They think e.g. the liquidity constraint caused by the bank run made them need to sell off assets at a discount to their true value. If they had realized the true value of the assets, if people had just been patient, they argue, the bank would have survived.

Back to deposit insurance

Deposit insurance schemes include what game theorists would call a commitment strategy. One way to maintain trust is the messy and complicated business of building it over time. In a bank run, that trust, carefully cultivated over years, can evaporate in a matter of hours.

Another way to maintain trust is to say “An algorithm, administered by someone much bigger than any of us, who has much less emotional skin in this game, is going to absolutely steamroll all the facts of this particular situation and do exactly what it is designed to do.”

The FDIC’s algorithm, in simplified form, is “If an insured financial institution fails, we will make absolutely positively sure that each depositor gets their deposits back, up to a limit of $250,000.”

The actual recovery formula is substantially more complicated. That coverage limit is per account type, a nuance that only financial planners could love. The definition of a depositor is exactingly specified down to what happens when people share ownership of accounts.

But what the FDIC tries to do is to make information-sensitive (“This particular bank is failing!”) debt, the deposits, again information-insensitive to most depositors. “Don’t worry, the U.S. federal government is good for more money that you’ve ever had. Don’t feel the need to come to the bank on Monday, unless you otherwise would have, in which case the money will absolutely be there.”

Businesses, which frequently have more than $250,000 to their names, have treasury management practices to limit counterparty exposure, including to banks. We’ll discuss those in depth some other time. This is also available to individuals as a product at e.g. many brokerages, to somewhat artificially boost their FDIC-insured limits while staying within the letter of all regulations. (The FDIC is not thrilled about this, but the products work as advertised for the moment.)

Orderly bank failures

How to ensure that the money is there on Monday? Well, the bank didn’t fail in a day. It has been making bad loans for years. Its supervisors (regulators) have almost certainly noticed its deteriorating health for a while. They told the bank to correct its loan practices and raise more capital. That didn’t happen.

So eventually, on a Friday, the supervisor (which is not the FDIC) tells the bank that it has failed. Concurrently with this, the FDIC swings into action. The micro-mechanics of this are fascinating; they resemble a police raid on the bank headquarters except mostly conducted by people who look like accountants (and in some cases, are).

That action is, in almost all cases, selling the deposits and assets of the bank to another financial institution. Banks benefit from scale. This is a core reason that they open new branches at the margin. The FDIC’s proposal is “Hey, a bunch of perfectly good branches with perfectly good bankers just came on the market. They’ve also got some assets and… well… nobody gets here if the assets are also perfectly good. But almost any pile of assets is good at the right price. Let’s make a deal.”

In cases where the bank is not actually insolvent—where they truly are just having liquidity problems—subsuming them into a larger, healthier bank solves the problem outright. The acquiring bank gets their assets at an attractive price, and the losses (the difference between the value of the assets and that attractive price) are borne by equity holders in the original bank, who will often be zeroed out or close to it. The FDIC prioritizes depositor recovery at lowest cost to the FDIC’s insurance fund, not the interests of bank shareholders. If you have reached this point, you have been called upon to perform the sacred duty of equity in a bank: take the L to preserve the depositors’ interests.

But what about in more advanced cases, where the loan book is so bad or market conditions are so stressed that the bank is insolvent? In these cases, the FDIC attempts to throw in a sweetener to the acquiring bank.

That sweetener often takes the form of a Shared Loss Agreement (SLA). Suppose, for example, that the FDIC models that a failing bank with approximately $100 million in deposits and $100 million in loans will probably take +/- $5 million in loan losses over the next few years. They could write an SLA with the acquiring bank saying “Here’s a $5 million cash payout which we will make to you immediately, covering these doubtful loans. You are contractually obligated to continue servicing them. If you actually get any recovery, wonderful, keep 20% for your efforts and send 80% back to us.”

The SLA is so-named because the acquiring bank and the FDIC’s insurance fund split the cost of loan losses. It could also be called a form of private leverage on the insurance fund. The private-sector equity in the acquiring bank absorbs much of the risk of the loan book, versus e.g. the FDIC having to actually sell the loan book in what is likely a distressed market. This theoretically minimizes the cash outlay of the insurance fund.

You can actually read through the list of bank failures and see how boringly functional this all is. For example, if you were a depositor at a tiny $100 million bank in Florida that you’ve never heard of, when it failed in 2020 you lost zero dollars and zero cents at a cost to the FDIC of about $10 million.

The Deposit Insurance Fund has about $120 billion in it.

The cost of insurance

The cost of deposit insurance is borne by banks, as a mandatory cost-of-doing-business. It generally scales with their total liabilities (prior to the GFC it was deposits only), and is weighted based on the perceived degree of risk, similar to most insurance pricing.

The insurance costs between 3 and 40 basis points per year, which you can compare to the interest rate you earn on your deposits. This magical failure-limiting technology is very not free. The exact determinants are mostly interesting to banking nerds.

One worthy of comment: a bank is charged modestly higher rates if they are heavily dependent on brokered deposits. As we’ve previously discussed in Bits about Money, brokered deposits are critically important to the economic model for brokerages and many fintechs. They’re also ruthlessly price sensitive deposits operated by professional money managers; most deposits are not. If professional money managers think a bank is imperiled theirs will be the first money out the door. Dependence on brokered deposits increases the risk of liquidity flight during times of stress and therefore increases the risk that the insurance fund will have to pay out more to cover a bank’s failure; accordingly, there is a surcharge for them.

This is also designed as a policy mechanism to encourage more banks to build more stable deposit bases. Building deposit bases takes hard work over many years doing the boring business of banking; that is why picking up the phone to a deposit broker is so attractive even where it is more costly to the bank.

The ultimate backstop(s)

The FDIC has at least two advantages backstopping its insurance scheme which more typical insurers do not.

The first is that it enjoys the “full faith and credit” of the United States government. If it depletes the entirety of the insurance reserve in a crisis, a) that is exceptionally bad news which the entire world will read about and b) depositors still get paid because the federal government cannot run out of money. This is, again, to maintain depositors’ trust in the money-ness of all deposits at all institutions, even the bad ones, “come hell or high water.”

The second is that the FDIC exists in a constellation with the Federal Reserve, which is the “lender of last resort” for banks. During crises, when the prices of many pools of assets tend to get even more correlated and organic buyers disappear for them (or charge increasing discounts to their notional values as the premium for liquidity increases), the Federal Reserve has the option of buying financial assets or lending money to financial institutions so that they can do the same.

This was one of the mechanisms for the Troubled Asset Relief Program (TARP). A full accounting of it is outside the scope of this essay, but most non-specialists believe it to have been more of a handout than it was. To an underappreciated degree, it substituted government liquidity for dried up private liquidity and successfully charged a premium for it.

Deposit insurance as ubiquitous infrastructure underlying everything

There are vanishingly few bank failures. This did not use to be the case. Deposit insurance was, along with the larger supervisory apparatus (and substantial ongoing work from the private sector), a major component in breaking the negative feedback loops which previously caused individual failures and repeated, frequent, systemic banking crises.

It is difficult to overstate how important this technology is. You rely on it to the same degree as you do electricity, running water, and stable Internet connections. Like much infrastructure, it is so good you’ll hopefully never even have to realize it is there.

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I write about the intersection of tech and finance, approximately biweekly. It's free.