Editors' note: This column is part of the Vox debate on "Lessons from Recent Stress in the Financial System"
The public bailout for cash-rich companies holding large deposits in the failed Silicon Valley Bank (SVB) may come across as an embarrassing and unseemly gift for an ultra-rich segment of society. While the bailout was legitimised by a funding tax on all other banks, the experience has made clear that society is still at the mercy of uninsured demandable claims.
Basel III sought to regulate intermediaries that promise safety on demand by adequate capital and liquidity backing. Unfortunately, the required regulations were soon rolled back in the US, even for huge regional banks such as SVB, First Republic, and Signature Bank.
These banks collapsed or were taken over upon a shockingly swift run by corporate depositors. While the ultimate cause was a traditional gamble on long-term rates at times of reduced supervisory powers, the contemporaneous failure of Credit Suisse suggests that even for Basel III-regulated banks, the low liquidity risk weights assessed for corporate deposits were wildly optimistic. A structural solution is now called for.
Dewatripont et al. (2023) review some options. A structural solution via new resolution norms would expand loss-absorbing capacity in case of default beyond what is reflected in current total loss-absorbing capacity (TLAC) and minimum requirement for own funds and eligible liabilities (MREL) norms, although many banks still do not satisfy current requirements. Such an investor bail-in inevitably requires bank default, but authorities are reluctant to act preventively to admit any bank distress, as any hint of bank default may be self-fulfilling. Preventive recapitalisations are too vulnerable to uninsured deposit runs at present.
Basel III envisioned bank recapitalisation by contingent convertible (CoCo) bond conversion while the bank is still a going concern (Kashyap et al. 2008, Hart and Zingales 2011), thus allowing such debt to count as AT1 capital. Yet, de facto or by design, going concern conversion was never triggered (Glasserman and Perotti 2017) so all CoCo debt converted at default until the Swiss wipe-out conversion of its AT1 CoCo bonds. The implication is that unless CoCo bonds are converted ‘a la Suisse’ to allow an orderly sale, they should not be allowed as Tier 1 bank capital since de facto they are only converted upon default (Perotti 2023a).
A second, quite extreme solution would extend public insurance to corporate deposits (Heider et al. 2023). This would supposedly be funded by higher deposit insurance fees, although all past experience suggests deposit insurance is structurally underpriced and not at all risk-sensitive. According to Dewatripont et al. (2023) as “protecting … company deposits only up to $250,000 or €100,000 means forcing them to face unnecessary risks, and for some big companies, this is almost like not insuring them at all, and this can be economically very costly”. Yet the economic case for fully insuring firms is far from clear. SVB clients and most corporate depositors held large balances well above the needs of current operations, as a store of value. There is no urgent public need to offer total insurance to business cash reserves. Companies earn their profits by assuming business risk and can bear a modest amount of price risk in exchange for immediate liquidity. While firms need some reliable store of value, they can (and routinely do) achieve this objective by investing in money market funds (MMFs) that do not promise safe principal. Business equity investors are rewarded for bearing risk, and are already personally protected by limited liability. In contrast, insured deposits serve a critical basic safety function for society.
The obvious stability issue is that it would be naïve to allow an uncapped guarantee to corporate or large individual deposits, even if counterbalanced by some requirements. Experience shows that public insurance is too often underpriced and boosts risk incentives. For some decades we believed that deposit insurance had eliminated runs, until we discovered that it stimulated more risk taking than what was anticipated or priced. The early evidence came from more frequent banking crises in developing countries that adopted deposit insurance.
At present, public responsibility to ensure safety for private savings works through a capped, minimum safe amount to all households. Deposit insurance was created in this form by the Roosevelt administration and copied all over the world for this purpose, not just to limit bank runs. It was not meant to create an ever-expanding public responsibility for corporate safety.
There are effective alternatives, with lessons drawn from the recent experience with regulation of MMF massive redemptions. MMFs as large corporate cash pools are a natural benchmark for corporate deposits. They offer two types of solution.
The first is to impose gates (temporary suspensions) upon rapid outflows. The alternative is properly pricing scarce liquidity by robust swing pricing, at increasing discount on par value. These solutions allow essential liquidity needs for salaries but do not promise 100% public backing of corporate cash balances.
In any bank run, allowing outflows at par value all the time naturally dilutes those who do not withdraw. As a result, once outflows start, all depositors have an incentive to run. To avoid triggering an escalation of run incentives, it is critical to slow down and discourage rapid outflows. A solution is to gate outflows in the form of a minimum balance at-risk for corporate deposits. Cipriani et al. (2023) propose allowing large but not complete withdrawals from large uninsured deposits, leaving a small amount (in their proposal, a modest 5%) to be paid out within 30 days, albeit with lower seniority than rolled-over deposits.
This column proposes to apply to any uninsured demandable claim a combination of gating (i.e. temporary or partial suspension of redemptions) and swing pricing when outflows become large. Thus, businesses would be ensured access to liquidity as required without creating escalation and avoiding a guarantee of their absolute safety. Outflows reflecting liquidity shocks do not need to escalate into full runs, as long as run incentives are contained by proper pricing of illiquidity.
The approach envisioned in the proposed regulatory reform for MMFs is swing pricing triggered by large outflows, which ensures investors recognize and price liquidity risk. Such a reform should satisfy necessary liquidity outflows (such as in March 2020), while reducing additional incentives to run to avoid dilution.
Maintaining current norms would force public authorities time and again to back any promise of absolute safety and liquidity on demand, well beyond household or corporate needs for current operations. Extending public insurance would stop runs at the unjustifiable cost of excess creation of safe promises. A solid reform must recognise that corporate cash reserves beyond transactional needs are best served under a MMF structure (within or outside banks), where run incentives are controlled by swing pricing and appropriate gates (Cipriani et al. 2023). Mandatory swing pricing, the key new U.S. Securities and Exchange Commission proposal for MMFs, would preserve access to liquidity to those in need while reducing run incentives by containing self-fulfilling fears of extreme dilution.
Protecting limited access to a safe store of value targeted to households’ and small firms’ demand for a minimum store of value seems a natural public mandate, not least because it offers a broad and stable foundation for intermediation (Perotti 2023b). Public policy should also protect access to reliable cash reserves for business. Yet, protecting the exact nominal value of corporate cash on demandable terms and in all circumstances serves no essential public purpose and leads to inflationary and fiscal risks. As a principle, since deposit insurance is capped, the same principle should apply to any form of public insurance for private claims.
Demandable claims seeking safety as a corporate store of value rather than required for basic payments should move to MMFs or equivalent intermediaries subject to illiquidity pricing, or remain as bank deposits under adjusted terms. Ultimately, reliable liquidity for business requires low price risk but does not require perfect safety (Gorton 2017). Confusing the two terms is poor economics and lends itself to capture by special interests. Unlimited insurance would inevitably represent a socialisation of business risk and a pricing distortion, and on both grounds it does not appear a legitimate public responsibility.
References
Cipriani, M, M Holscher, P McCabe, A Martin and R Berner (2023), “Mitigating the Risk of Runs on Uninsured Deposits: The Minimum Balance at Risk,” Liberty Street Economics, Federal Reserve Bank of New York, 14 April.
Dewatripont, M, P Praet and A Sapir (2023), “The Silicon Valley Bank collapse: Prudential regulation lessons for Europe and the world”, VoxEU.org, 20 March
Financial Times (2023), “Regional US banks claimed easier capital rules would turbocharge loans”, 17 April.
Hart, O and L Zingales (2011), “A New Capital Regulation for Large Financial Institutions”, American Law and Economics Review 13(2): 453-490
Heider, F, J P Krahnen, L Pelizzon, J Schlegel and T Tröger (2023), “European lessons from Silicon Valley Bank resolution: A plea for a comprehensive demand deposit protection scheme (CDDPS)”, SAFE Policy Letter No. 98
Kashyap, A, R Rajan and J Stein (2008), “Rethinking capital regulation”, in Proceedings-Economic Policy Symposium-Jackson Hole, Federal Reserve Bank of Kansas City, pp. 431-471.
Glasserman, P and E Perotti (2017), "The Unconvertible CoCo Bonds", in Achieving Financial Stability: Challenges to Prudential Regulation, World Scientific Publishing, pp. 317-329.
Gorton, G (2017) “The history and Economics of Safe Assets", Annual Review of Financial Economics 9: 547-586.
Perotti, E (2023a), “The Swiss authorities enforced a legitimate going concern conversion”, VoxEU.org, 22 March.
Perotti, E (2023b), “A Safe Mandate at the Heart of Central Banking”, mimeo, ABS.
Perotti, E and J Suarez (2011), “A Pigouvian Approach to Liquidity Regulation”, International Journal of Central Banking, December.
Weitzman, M L (1974), "Prices vs. Quantities", Review of Economic Studies 41(4): 477-491.
