Preventing bank runs

The guy writing the Forbes article sounds kind of nutty to me. It's certainly interesting to see people challenge the current set of beliefs if only because it helps to ensure that we really are fact-checking. But I don't buy it.

The deposit insurance stuff is really interesting to me. On the face of it, it would seem like a bank run is unlikely - anyone with less than 100k in a bank would be irrational to take out their money, right? But I think there's more to it.

First, it depends on the belief that the government can afford to pay out that money. As is fairly well-documented, the FDIC itself is pretty under-capitalized right now. The FDIC has some $53B in available funds - a worst-case resolution of the Washington Mutual failure would have eaten $20B of that. If there were a systematic bank run (i.e. several national banks in a nation-wide panic, not a few isolated cases) the FDIC wouldn't be able to back all of it. It seems fairly clear that the Fed and Treasury would then bail out the FDIC, but ... would you want your money depending on that?

Second, it depends on the belief that you will get your money back quickly. Given the option, do you want to go through the hassle of having the government figure how much they owe you and pay it out? Best-case that takes a few weeks, and a large number of Americans live paycheck-to-paycheck. Obviously the timeline involved gets much worse if the government has to bail out the FDIC.

Third, there's actually a surprising amount of money outside the limits of what's FDIC-insured. I know a couple people who've had to move money around to get under the per-bank cap, so my guess is it's probably more like 90% of Americans have their deposits fully-covered by the FDIC. This article, http://www.economist.com/finance/displaystory.cfm?story_id=12342681, suggests that some 38% of money in deposits is outside the coverage of the FDIC at the old 100k limit, and that 27% will remain outside the coverage after the bump to a 250k limit (my guess is most of those are retirees' accounts - the truly wealthy fat cats aren't storing their money in savings accounts). So even if people withdraw just what's outside the FDIC insurance, that's 27% of deposits (though presumably some fraction of that would then be deposited in a savings account at another bank).

So it does seem like there's some cause for concern about bank runs. And then there's the example of Washington Mutual. WaMu obviously got itself in trouble through risky mortgages and other financial voodoo. But what pushed the bank from "uh oh" to "oh shit" was that over a ten-day period depositors withdrew some 16.5B - essentially, speculation that the bank was going to go under caused a bank run, which in turn pushed deposits so low that the bank did buckle.

From http://www.economist.com/finance/displaystory.cfm?story_id=12321761:

"Even more alarming, WaMu's demise shows that depositors will flee the most troubled banks, even when their money is backed by the state.

WaMu had been struggling for months. Reckless expansion during the housing boom saddled it with more than $50 billion in option adjustable-rate mortgages, among the most likely to explode when markets turned. But its troubles accelerated after the bankruptcy of Lehman on September 15th. Over the following ten days, frightened depositors yanked almost a tenth of their money, despite a federal guarantee of all deposits up to $100,000."

Which is a long way of saying that while I think a legitimate nation-wide bank run is unlikely, I do think there's a legitimate risk that regulators ought to focus on preventing.

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The other big group that have large accounts in banks, it turns out, are mostly small businesses that have to make payroll. Obviously they have to keep a fairly large amount of cash on hand to pay everyone every month (those of you with real jobs will probably recall on your paystubs that the company parks its payroll money in Wachovia or Wells Fargo or somesuch bank).

So for them it's a double whammy. On one hand they lose the money that they use to regularly make payroll if a bank goes under. On top of that, they have to fight a federal regulator to get out the money that they just had insured. Also, whereas private people can move money around to multiple banks to get under the $100,000 (or $250,000 caps or whatever), this is obviously not a possible strategy for small businesses that use it for payroll and ongoing expenses.

And, in fact, they're relatively more incentivized to figure out what's going on at their bank - if they can't make payroll for two weeks because of a bank problem and all of their checks bounce, customers are going to go away and employees are going to quit.

In the end, bank runs these days are more likely to occur via small and large businesses transferring away money than they are having grannies lining up around the block...

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Thank you for the links J and expanding upon the ambiguities of deposit insurance. Yeah I guess the numbers just don't add up - the FDIC has $53B, which equals only 1.5% of all US bank deposits. But say this crisis gets worse and the FDIC actually needs to clear its shelves and even take loans from the Fed to reimburse customers from more big failed banks. That is kind of an economic doomsday scenario anyway - so I don't think any amount of preparation or safeguards would be enough. $100k, $250k, $1M - people will lose major money and maybe a run on the remaining solvent banks would happen anyway.

Like no matter what they promise, home insurance companies are just physically unable to cover all claims from huge disasters like an 8.0 quake in SF-LA or a Katrina (I guess similar to how AIG couldn't possibly pay out if all their credit-swaps went bad). So they try to weasel their way out through contract loopholes, stall with red tape, or shortchange customers on damage assessments. People should know that before taking out a policy, and probably by now they do. I guess that's why there's a new push to have a disaster relief fund run by Washington and funded by tax dollars, which might give people more "confidence" that the money in their homes will be protected. But those two examples lead me to wonder if it's proper for the government to play the role of guarantor against any and all public catastrophes. Maybe it was feasible in New Deal times, but investments are more costly and complex these days, and the effects of disasters spread further. Shit happens, and human government is not wise and efficient enough to protect us against the larger natural or man-made disasters. Now some insurance is relatively "easier" for the state to guarantee, like retirement and health care, but we just lack the political will for the required sacrifices and reforms (but that's a separate discussion).

Regarding bank runs, hopefully more stable banks will just buy up the struggling ones and cover threatened deposits that way, as was the case with Wachovia, so the FDIC doesn't have to step in. Competitors recognize deals and will pounce when they can. Or the government will force a buyout, like they did with JPMorgan-Bear? But for WaMu's case, they were extraordinary screw-ups, so hopefully other banks won't get in such hot water and incur the justified run. I'm just amazed they were able to pull an Enron for so long and dupe customers into thinking that they would take care of their money. Maybe people assume that large banks are safe (like how I assumed that Palin, being a state governor, would know how to give interviews), or was it the free checking!?! I guess so much of it is psychological as the Economist said - just make sure people at least have a shred of confidence in their banks to let their money stay put, earning 2%. Well, the SEC decided to prohibit short-selling of some stocks, but not others, this month. Can the government prevent bank runs by blocking large withdrawals? It may not be Constitutional, but it's for the greater public good, right?

Well, if the premise behind the Wall Street rescue is that the Fed is large and stable enough, and not burdened by the short-term constraints of a publicly-traded company, to hold onto toxic securities until they turn profitable, can we apply that to private banking too? The Treasury/Fed used to be the "lender of last resort", but obviously that has gone out the window, as commercial entities as well as financial institutions are now getting cash advances. If we can't trust private bank wackos like WaMu to safeguard our money and respect risk, then could private citizens have savings accounts at the Fed instead? Why borrow from China when they can borrow from us? 30-year T-notes aren't flexible enough (though they are considering bringing back the 3-year note). Just thinking out of the box here. Like Freddie and Fannie (in theory), they could offer a safer alternative than commercial banks, and customers can make the choice. It would also incentivize private banks to be more cautious, or risk losing business to Uncle Sam.

To close, some of my coworkers were wondering if our company's cash reserves (in the billions) are similarly protected in case of bank failure. Like A mentioned that small businesses might want to withdraw their cash, because it may exceed the $250k protection limit and they need security because they have daily expenses to cover to stay alive. But of course large companies have billions, so where the heck do they put their cash? And is it any safer? Cayman Islands and Suisse? I guess a lot of big companies just become banks themselves, like GE and Toyota?