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 U.S. banks to fund more of their loans and investments by issuing long-term 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 U.S. 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 U.S. 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 vaporized, 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 non-existent. 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 U.S. 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 U.S. 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.

There’s an argument for going even further, forcing even smaller lenders to issue debt too. True, that wouldn’t work for the thousands of tiny American banks that would struggle to find a market for their bonds, and which can mostly fail without causing a systemic crisis. But for those 130-ish banks above, say, $10 billion in assets, being able to raise debt at a reasonable price in the capital markets is a pretty good test of being able to demonstrate a viable business model. Having a more extensive market for mid-sized banks’ debt could thus stop the weakest ones from growing, easing the risk of moral hazard that stems from deposit insurance.

The trickier part is figuring out who ultimately bears the cost of loss-absorbing debt. If a bank fails, it’s obvious: the bondholders get wiped out or converted to equity. But they ought to seek compensation for this risk from the outset by charging the bank more interest. In that case, the burden would really be passed on to shareholders through lower returns, or customers through pricier loans and other fees.

That shouldn’t deter the regulatory agencies from pushing ahead. Someone has to pay for a safer banking system. Shareholders and customers already fund deposit backstops through periodic bills from the FDIC, such as the $15.8 billion it is now charging lenders for the protection offered to uninsured customers at SVB and Signature. Relying more on loss-absorbing debt could make such giant ad-hoc bills less likely in the future.

Context News

Banks in the United States with more than $100 billion in assets may have to issue loss-absorbing long-term debt to increase protection for depositors in case of failure, Federal Deposit Insurance Corporation Chair Martin Gruenberg said on May 18. Speaking to the Senate’s Committee on Banking, Housing, and Urban Affairs, Gruenberg said that an added debt buffer would have protected uninsured depositors in recent banking failures. The FDIC has estimated that it will take a combined $31.5 billion hit from the collapse of Silicon Valley Bank, First Republic Bank and Signature Bank.

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