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Deposit insurance is key to the confidence trick of banking

You might think that bank regulators would be feeling a little jittery these days — in short order, three US lenders and the globally systemic Credit Suisse became victims of a not-so-mini-banking crisis that all too closely resembled the chaotic collapses of 2007-08.

Instead, there is a quiet sense of satisfaction. The failures were contained — at least for now. New regulatory mechanisms were deployed swiftly. And, perhaps most importantly, a push for deregulation among politicians on both sides of the Atlantic has been staunched.

There is even an opportunity to toughen some rules. Last week, Bank of England governor Andrew Bailey declared that the UK’s deposit insurance scheme, which guarantees £85,000 of a customer’s money, may need reforming — and chancellor Jeremy Hunt agreed. Recent bank collapses, they said, had highlighted that a credible deposit guarantee scheme was key to maintaining confidence in banks.

Without confidence, the modern norm of fractional reserve banking — which allows a bank to fuel economic growth by lending out for long periods far more than it keeps on hand in easy-access deposits — is fragile.

Over the years that fragility has been repeatedly exposed. The infamous 2007 run on Northern Rock has made UK regulators particularly alive to the risks. This year, similar fates befell Silicon Valley Bank and Credit Suisse. In a digital era of instant transferability of funds, and panics spread by social media, this is a bigger problem than ever.

Deposit insurance schemes — the norm in many developed markets to safeguard customers’ money — are typically funded on a pooled mutual basis across the banking sector. The US scheme, which guarantees $250,000, is one of the most generous.

But the recent drama has made it obvious that even ostensibly generous schemes are not fit for purpose. In the US, there was a fateful 2019 deregulatory initiative, exempting regional banks from capital and liquidity safeguards. In the case of SVB, which had very high average deposit levels, there was the added issue that the vast majority of customers’ money wasn’t covered by deposit guarantees.

In an effort to calm panic, the Fed pledged an unlimited state guarantee on SVB deposits. And policymakers said a similar pledge could be made if other systemically important banks got into trouble.

Even the UK’s low-level involvement in the SVB affair — with its UK operations sold to HSBC for £1 in a scheme orchestrated by policymakers — was sufficient to spur the deposit guarantee rethink.

There are several changes being considered by the BoE. Most obviously there is a question about the quantum of the guarantee. If the £85,000 figure had kept pace with inflation over the past decade, it would have risen to far in excess of £100,000. Such a change would do little to alter depositors’ behaviour in a panic. On the other hand, there is a clear argument for making the guarantee far higher for business account holders, who may flee faster.

More profoundly, the Bank of England is considering moving to the US model of having a properly pre-funded pool that could allow depositors in a failed institution to get near instant access to their money, rather than having to wait a week or more while the current system calls up contributions from participating banks. This is likely to be unpopular with banks, but it could help guard against the kind of panic that leads to runs.

Policymakers are also considering how the deposit guarantee interplays with rules, such as the liquidity coverage ratio, dictating the level of liquid funding a bank must maintain. The LCR currently assumes an implausibly low maximum outflow of 20 per cent of retail customer deposits in a month. Even a bank such as Northern Rock, in a period before today’s degree of digitisation, rapidly lost more than half of its customer deposits.

There are knock-on implications, too, for banks’ bond issuance. Bonds designed to be “bailed in” if a bank is failing, now yield sharply more than they did before recent events. This potentially makes it hard for some banks, especially smaller ones, to comply with their regulatory capital requirements — a more robust deposit insurance scheme, with higher costs for these banks, could be an alternative.

Such reforms are essential before the shortcomings of the current system do real damage. The UK is asking the right questions; the US has bigger loopholes and shouldn’t delay in closing them.

patrick.jenkins@ft.com

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