How Long-Term Bank Debt Could Help Strengthen Deposit Guarantee Systems

Banking watchdogs in the US are studying changes to deposit guarantee systems after the bankruptcy of various entities. But one of the most promising solutions has little to do with collateral, or even deposits. Requiring more banks to finance more of their loans and investments by issuing long-term debt, and relatively less by deposits, could offer an additional layer of protection for customers. The only question is who bears the cost of the extra security.

Globally systemic US megabanks like JP Morgan are already issuing loads of loss-absorbing bonds, a product of post-2008 regulations designed to end bailouts. But unlike in Europe, where even small banks finance themselves with this type of debt, the vast majority of those in the US don’t have to. It’s a problem for depositors, as long-term debt also acts as a buffer for clients.

It works like this: if the assets on a bank’s balance sheet are reduced – for example, because the loans or securities it owns lose value – the liabilities on the balance sheet must also be reduced by the same proportion. The first to suffer the impact are own funds. Once they have evaporated, the unsecured debt issued by the bank will be next. And if this were not enough, depositors not covered by government guarantees are in line for bankruptcy, which gives them an incentive to withdraw their money if they perceive danger.

Something similar happened with SVB, First Republic and Signature Bank, the three banks that failed in March and April. They had respectable capital ratios, around 8.5% of assets on average at the end of 2022, including common equity and preferred shares. But the added layer of loss-absorbing debt protection was almost non-existent. Compare JP Morgan and Bank of America, whose clients are protected by a gigantic slab of long-term loans, which in the event of a crisis would be lost before deposits.

The difference helps explain why it was so expensive for the US Federal Deposit Insurance Corporation (FDIC), which backs the bank accounts, to liquidate the three banks. The agency chaired by Martin Gruenberg has estimated the cost at 31,500 million dollars, a bulky 6% of combined assets. Partly in response to this blow, Gruenberg and several lawmakers have proposed various options to extend share insurance beyond the $250,000 limit, which could help make bankruptcies less frequent.

Forcing the issuance of more long-term bank debt could also make it cheaper. Imagine that SVB, First Republic and Signature had loss-absorbing debt equal to 4.5% of their assets, around the threshold required of systemic banks globally. In this scenario, assuming bondholders lose everything, the global losses for the FDIC would have been cut in half, to about $15 billion.

The FDIC and other agencies are already studying the option of introducing long-term borrowing requirements for banks with more than $100 billion in assets, Gruenberg says. With this, the number of banks forced to issue loss-absorbing bonds would go from 8 to about 30. For Gruenberg and Congress, it would be much less risky to expand deposit insurance, since future blows would be less.

There are arguments to go even further and force the smallest to issue debt. True, that would not work for the thousands of small banks that would have a hard time finding a market for their bonds, and most can fail without causing a systemic crisis. But for those 130 entities with more than, say, $10 billion in assets, being able to get debt at a reasonable price in the capital markets is pretty good evidence of having a viable business model. Having a broader market for the debt of midsize banks could impede the growth of the weakest, alleviating the moral hazard that stems from deposit insurance.

The most difficult part is determining who ultimately bears the cost of loss-absorbing debt. If a bank fails, it’s obvious: the bondholders lose everything, or it becomes capital. But they should seek compensation for this risk from the start, by charging the bank more interest. In that case, the burden would actually be shifted to shareholders through lower returns, or to clients through more expensive loans and other fees.

This should not deter regulators from going ahead. Someone has to pay for a more secure system. Shareholders and customers already fund deposit protection through periodic bills from the FDIC, such as the $15.8 billion it will charge banks for protection offered to uninsured customers of SVB and Signature. Relying more on loss-absorbing debt could make those giant ad hoc bills less likely in the future.

The authors are columnists for Reuters Breakingviews. Opinions are yours. The translation, of Carlos Gomez Downit is the responsibility of Five days

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