How risky bank debt makes customers safer
Bank watchdogs are mulling changes to deposit insurance schemes after a string of lenders failed. Yet one of the most promising fixes has little to do with insurance, or even deposits.
Forcing more US banks to fund more of their loans and investments by issuing longterm debt, and relatively less with deposits, could offer an extra layer of protection for customers. The only question is who shoulders the cost of the extra safety.
Globally systemic US megabanks, like Jamie Dimon’s Jpmorgan, already issue oodles of loss-absorbing bonds – a product of post-2008 regulations designed to end government bailouts.
Yet unlike in Europe, where even small lenders fund themselves with this class of debt, the vast majority of US players don’t have to.
That’s a problem for depositors, since long-term debt acts as a buffer for customers too.
It works thus: if the asset side of a bank’s balance sheet shrinks – say because loans or securities it holds fall in value – the liability side of the balance sheet must get crunched too by the same amount. First to take the hit is equity.
Once that has been vaporised, any unsecured debt the bank has issued will be next. And if even that isn’t enough, depositors not covered by government insurance schemes are in line for the chop, giving them an incentive to rip out their money if they sense danger.
Something like that happened at Silicon Valley Bank, First Republic and Signature Bank, the three lenders that failed in March and April.
The trio had respectable capital ratios of about 8.5% of assets on average at the end of 2022, including common equity and preferred stock.
The extra layer of protection from loss-absorbing debt, however, was almost nonexistent.
Compare that with behemoths Jpmorgan and Bank of America, whose customers are shielded by a giant slab of long-term borrowings, which would get wiped out before deposits in a crisis.
The difference helps to explain why it was so expensive for the Federal Deposit Insurance Corporation, which backstops US bank accounts, to wind the three lenders down.
The agency chaired by Martin Gruenberg has tallied the total cost at $31.5 billion – a chunky 6% of combined assets.
Partly in response to that thwack, Gruenberg and several US lawmakers floated various options for extending deposit insurance beyond the current $250,000 limit, which might help to make bank runs less frequent.
Forcing the issuance of more long-term bank debt could make them cheaper too.
Imagine that SVB, First Republic and Signature had loss-absorbing debt equivalent to 4.5% of their total assets – roughly the required threshold for globally systemic lenders.
In this scenario, assuming the bondholders got wiped out completely, the overall losses to the FDIC would have been roughly halved to about $15 billion.
The FDIC and other agencies are already considering introducing long-term debt requirements for banks with more than $100 billion of assets, Gruenberg said in a recent speech.
Doing so could swell the number of lenders compelled to issue loss-absorbing bonds to about 30, from eight now. It would make it a lot less risky for Gruenberg and Congress to expand deposit insurance, since future hits would be lower.