First Republic Bank Closure Sparks Debate on Deposit Insurance Limits

First Republic Bank has been closed due to the massive losses in its asset portfolio and a subsequent bank run. The federal government has provided an unconditional guarantee for all deposits in “systemically important” banks except for small community banks. The failure of First Republic Bank will result in a significant loss for the Federal Deposit Insurance Corp. (FDIC). The FDIC’s loss will be the difference between what it pays JPMorgan Chase to assume all of the bank’s deposits and what it nets in liquidating the bank’s remaining assets and liabilities not assumed by JPMorgan.

The $250,000 deposit insurance limit is no longer relevant for large banks, and it should be the same for all banks. The idea that large depositors should withdraw their deposits from a bank when they sense that it might fail has little to no therapeutic value in deterring reckless banking. Bank runs are harmful, and they drive a troubled bank deeper into trouble, causing incalculable damage to many of the bank’s borrowers, especially businesses with lines of credit that get canceled when a bank is suddenly closed. The failure of a business can harm the community and spread the pain of the bank’s failure to innocent parties.

Over the last ten years, only four out of 74 bank failures have resulted in deposits not being fully protected against loss. It is clear that the FDIC has repealed the $250,000 insurance limit as a practical matter. Therefore, Congress must recognize that bank regulations and their complement, bank supervision, have repeatedly failed to perform satisfactorily, as seen today.

The FDIC has attempted to charge a risk-sensitive deposit-insurance premium in recent years, meant to deter unwise banking practices, notably the kind of bad lending that often leads to bank failure. Unfortunately, the FDIC’s premium formula is based on relatively noncontroversial, lagging measures of banking risk, such as nonperforming loans, and by the time bad loans are identified, the damage has already occurred.

To ensure a financially sound deposit insurance or guarantee program of any type, premium rates must discourage unwise banking practices, such as rapid asset growth, excessive loan concentrations, or premium-rate structures that fail to reflect actual credit risks. A market-driven mechanism must be developed to properly price deposit-insurance premiums, just as market economies have long relied upon financial markets to price credit risk, an essential element of the banking business.

Insurance contracts are options contracts, and option-pricing techniques should be utilized to price deposit insurance. The market-driven mechanism should produce much better pricing of deposit insurance than the FDIC can produce.

A full guarantee of all deposits in a bank has become a political reality and an economic necessity. The public-policy challenge is to construct a market-driven mechanism that properly prices deposit insurance premiums in a manner that incentivizes sound banking and, as a consequence, ensures better pricing of the credit and other risks banks assume in financing a market-driven economy.