Saturday, March 11, 2023

Free vs Regulated Banking: What Does SVB's Collapse Tell Us About Depositor Losses During Canadian Free Banking?

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7 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff has a few words to write about the warp speed collapse of Silicon Valley Bank (SVB), deposit insurance, and even a connection to his ongoing series on free banking in Canada.

The Economics Correspondent just read today that 87% of failed Silicon Valley Bank’s deposits are uninsured, even though it’s an FDIC member. 

87% of deposits are at risk because the FDIC only insures accounts up to $250,000 per depositor. And SVB, the 16th largest U.S. bank by assets, has many wealthy customers including individuals and businesses who draw on deposit accounts to make payroll.


The Economics Correspondent had originally decided not to write in detail on the subject of deposit insurance and depositor losses during Canadian free banking, but SVB’s sudden collapse has provided a timely segue to comment.

Canada had no deposit insurance until Parliament established the Canadian Deposit Insurance Corporation (CDIC) in 1967. 

Although there was never a financial crisis during Canada’s earlier free banking era (1817-1935), isolated banks did fail from time to time since banking is, after all, a profit/loss business just like any other.

Critics of free banking argue that absent deposit insurance customers can become nervous, withdraw their funds en masse, and set off a run which could spread to other banks and spawn systemic crisis (oddly, there has never been a financial crisis in Canada). 

Deposit insurance, they say, assuages such fears and makes the banking system more resilient to runs while protecting customers from losses.

Critics of deposit insurance argue it introduces moral hazard both to bankers and their customers since both sides, aware that government guarantees will cover their losses, become less interested in managing risk.

The moral hazard story, they argue, was evident during the 1980’s S&L Crisis. 

During the late eighties thrifts that had gotten in trouble offered absurdly high deposit interest rates, attracting new funds to make extremely speculative all-or-nothing loans in a desperate attempt to avert failure.

But depositors handed their money to institutions they knew were on the brink anyway, indifferent to anything but high yields since they knew the government would cover their losses if the thrift failed.

Instead of prudence S&L depositors cared only if there was an FDIC or FSLIC sticker in the bank’s window.

Subsequently the final cost of the S&L depositor bailout swelled by tens of billions of dollars, a substantial sum back in the 1980’s and a prima facie example of deposit insurance enlarging both a financial crisis and its bailout price tag.

But critics of uninsured deposits have one more, undeniable piece of evidence to support their case: the empirical history of Canada. During free banking some depositors did lose money in the isolated bank failures that occurred from time to time.

Using historical records economists have estimated that in the latter third of the 19th century total Canadian depositor losses totaled less than 1% of failed bank liabilities across the entire period (Selgin, 2021).

Losses were so small in part precisely because there was no deposit insurance in Canada at the time. Instead bank owners and directors were liable for depositor losses up to double their paid-in-capital stake (ie. double liability). 

Having their personal assets at stake focused Canadian bank owners and directors like a laser on sound lending and credit quality.

(Note: During the same period the United States endured several banking panics where estimated depositor losses totaled 57% of failed bank liabilities)

A Federal Reserve report confirmed the trend all the way until 1931 using assets, which are a rough analog to liabilities, bringing the trend total to about 65 years:

"For the period 1901 to 1920 the assets of suspended banks in Canada amounted to about one-half of one percent of the average yearly banking assets of the country... ...For the eleven year period 1921-1931 the assets of suspended banks in Canada were again equal to about one-half of one per cent of the average yearly banking assets of the country while the corresponding figure in the United States was about twenty times as high, or 10.7 per cent."

-"Branch Banking in Canada," Federal Reserve Committee on Branch, Group, and Chain Banking (1932)

Nevertheless, proponents of deposit insurance maintain that even losses of less than 1% are unacceptable. Depositors, they say, should enjoy guarantees they will lose nothing in the event their bank fails. And the FDIC has made good on that promise, with no one losing a penny in insured deposits since its inception in 1933.


The key phrase the Correspondent would like to stress here is “insured deposits.” Because deposit balances over the FDIC limit ($250,000 per depositor since 2008) are uninsured and therefore ineligible for compensation.

The Economics Correspondent hasn't been able to find total U.S. *uninsured* deposit losses for the 90 years the FDIC has been in business, and the FDIC understandably isn’t keen on announcing such numbers loudly.

However the recent SVB story is quite informative. SVB’s recent annual report documents that in December of 2022 at least 87% of its deposits were above the FDIC limit and therefore ineligible.

Out of curiosity the Economics Correspondent checked JP Morgan Chase's most recent annual report and found over $1 trillion in uninsured deposits.

Given the sheer amount of money wealthy and business clients have in U.S. banks the Economics Correspondent would venture that depositor losses in America’s two post-1933 crises—the S&L Crisis and the Great Financial Crisis—have far exceeded 1% of liabilities.

In fact we already know something about S&L Crisis losses.

Depositor losses were so great in the late 1980’s that the Federal Savings and Loan Insurance Corporation (FSLIC) itself went bankrupt and had to be absorbed into the FDIC. S&L depositors were stuck holding the bag and the U.S. taxpayer had to make up the difference. 

The S&L bailout ultimately cost taxpayers $132 billion or roughly 15% of the entire industry's liabilities (not just failed institutions as measured in Canada).

Cautious Rockers may also remember the taxpayer was on the hook for over $400 billion in capital injections during the 2008 financial crisis to prevent losses that would have easily bankrupted the FDIC.

Ultimately the $400+ billion was repaid with interest, so unlike 1990 taxpayers weren't forced to permanently subsidize depositors, but the point is without putting a huge amount of taxpayer money at risk the FDIC itself would have become insolvent and uninsured depositor losses would have been enormous.

And this doesn’t even include the smaller waves of bank failures that occurred in the mid/late 1930’s plus the decades worth of intermittent bank failures that have occurred since then.

Hence, even though the Economics Correspondent is having trouble finding uninsured depositor losses for the 1933-2023 period, he’ll still bet a steak dinner with anyone that depositors fared better under Canadian free banking (< 1% losses) than they have in the USA even with the FDIC and FSLIC.


As for SVB itself, the Economics Correspondent is confident that not all of its 87% in (uninsured) deposits will go unpaid. But there is a reasonable chance that there will be *some* losses.

It all depends on the final disposition of the bank. 

If the FDIC is able to find a buyer for SVB, a large firm that’s willing to take over its assets and liabilities and enter into a loss-sharing agreement with the FDIC, all in exchange for SVB's branch network footprint and customer base, then even uninsured deposits might be made whole.

But if the bank has to be wound down—its assets sold and its liabilities paid off—uninsured depositor losses become much more likely. 

SVB’s balance sheet claims assets in excess of liabilities, but in the rapidly rising interest rate environment of late 2022/early 2023—which is rumored to have triggered the bank’s difficulties to begin with—the mark-to-market value of those assets comes into question.

SVB is a bit different from your average bank in that over half of its assets are securities—not loans—such as Treasuries and mortgage backed securities.

As interest rates have risen rapidly the value of those securities has fallen, and if SVB were to wind down and sell all its securities at depressed rates there might not be enough cash to pay off all depositors.

Of course the FDIC will make up the difference for every depositor up to $250,000 apiece, but anyone with more at stake will be out of luck.

And the FDIC won’t mention those losses… at least not very loudly. And neither will critics of free banking.


Postscript: For anyone wondering if the Economics Correspondent is advocating the abolishment of deposit insurance in the United States, the answer is a qualified no. 

The pros and cons of deposit insurance can be complicated, but in a single phrase the Correspondent’s opinion is this: So long as a monopoly central bank, politicians, and all their destabilizing regulations exist, then deposit insurance serves as an imperfect, liability-laden, but nevertheless effective remedy for quelling the panics created by Washington, DC.

However history clearly demonstrates that when politicians haven't interfered with banking systems the industry has functioned extremely well on its own, and that deposit insurance has not only been unnecessary, it has actually introduced moral hazard and greater risk into the system.

In fact the moral hazard problem is precisely why U.S. Congress rejected 150 separate bills attempting to establish federal deposit insurance legislation from 1880 to 1933. It's also why most developed countries didn't introduce deposit insurance until the late 20th century—the United States being one of the first in 1933 only after Czechoslovakia—and Australia and New Zealand had no deposit insurance until 2008.

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