Yellen’s Comments Create the Worst of All Possible Worlds for Banking Incentives

Small banks just can't catch a break.

It’s been a few weeks since the failure of Silicon Valley Bank (SVB). In my previous article about the bank failure, I argued against a bailout of both investors and depositors. Regulators allowed investors to lose their lunch in the bank failure, but ultimately decided to bail out depositors.

As a quick summary, Silicon Valley bank did not have enough money to give bank customers the money they deposited due to some bad management of the deposits and volatile Federal Reserve policy.

Normally, banks pay the FDIC to insure customer account balances up to $250,000. The problem, though, is that several customers had deposit accounts over the $250,000 amount.

This left regulators with a choice. Follow the rules they set, or break the rules to bail out depositors. They chose the latter.

But this led to a host of new questions for Treasury Secretary Janet Yellen. Most importantly, is the new FDIC policy to insure all deposit accounts up to any amount?

Yellen gave a disturbing answer, but, before we examine it, we need to examine a worrisome trend in banking—the consolidation of the banking industry.

Banks Are Getting Bigger

Over the last 40 years, there has been a clear trend of bigger banks taking over the industry. Several metrics point to this fact.

If you look at the raw number of FDIC insured banks, the industry remained relatively close to 14,000 banks from 1935 to 1985. However, in 1985, that number steadily declined to a little over 4,000 at the end of 2022.

But it’s not just the number of banks that reflects this trend. A Harvard study found that community banks’ share of lending and assets fell by 40 percent from 1994 to 2015.

So what’s going on? Well, to a certain extent there may be technological changes driving banks to consolidate, but many suspect banking regulations are a major culprit.

As banking regulations increase in number and complexity, large banks with pre-existing teams of accountants, lawyers, and lobbyists are more able to handle regulatory compliance.

Furthermore, when the government creates banking industry regulations, it brings large banks to the table. This gives them an advantage in crafting regulations which suit them. Economists call this concept regulatory capture, and whistleblower Carmen Segarra’s tapes all but prove this is an issue.

And now Secretary Yellen is dumping gasoline on the fire of community banking.

Sending a Message

So, when senator James Lankford asked if, going forward, all depositors would be completely insured, secretary Yellen gave a telling answer:

“A bank only gets that treatment if a majority of the FDIC board, a supermajority of the Fed board, and I in consultation with the president, determine that the failure to protect uninsured depositors would create systemic risk and significant economic and financial consequences.”

So SVB depositors were only insured because the experts believed that not bailing them out could have had a detrimental effect on the whole economic system (perhaps triggering a recession).

On its face, this seems like a sensible answer. Bailing out depositors was used to prevent an economic crisis, so this option should only be used in preventing future crises.

But ask yourself for a minute, which kinds of banks would represent systematic risks to our system? You guessed it—big banks.

In other words, Secretary Yellen is more or less saying depositor bailouts are only for banks that are “too big to fail.” If you’re Community Bank of Springfield or any small town bank, sorry. Depositor bailouts are for irresponsible fat cats.

This sort of statement creates terrible incentives in the banking system. Imagine you’re a small business with deposits exceeding $250,000. Why would you ever choose to keep your money in a small community bank now?

If that bank fails, you could lose all your deposits over $250,000. If you keep it in a massive national bank instead, you’re guaranteed a bailout.

So not only does this new policy totally disincentivize depositors from checking on the financial stability of national banks, it actively discourages them from investing in community banks.

For community banks, local businesses are often the biggest depositors. How can these banks ever compete with an asymmetric 100% insurance system for their biggest competitors?

It would be difficult to craft a worse system for smaller competitors than what regulators have made in the modern banking industry.