Sedona Arizona

Banking and FDIC Insurance

Banking systems and FDIC insurance have captured public interest in the wake of the Silicon Valley Bank (SVB) failure.

How much do you know about the fractional reserve banking system?

In a fractional reserve banking is a system, banks are required to hold only a fraction of their deposits in reserve. They are free to lend out the remainder of deposits on hand. The system allows banks to create credit and expand the money supply.

This is the primary reason a bank can fail. A classic “run on the bank,”causes this when withdrawal demands are higher than available reserves.

How the factional reserve banking system works

An overview of the fractional reserve banking system:

  • A customer deposits money in a bank. The bank keeps a fraction of the deposit as a reserve and lends out the rest.
  • Borrowers take loans and spend money. Those funds make their way to other banks. The banks also keep only a fraction of the deposit as a reserve.
  • This process continues, with each bank holding a fraction of each deposit as a reserve and lending out the rest. This is a multiplier effect on the original deposit.
  • The new money created through this process funds economic activity. This increases consumer spending, business investment, and government projects.
  • Banks earn interest on the loans they make. This is how they generate profits above the amount of interest paid to depositors.
  • The central bank (i.e. Federal Reserve in the United States) regulates the money supply.
  • FDIC insurance protects depositor funds up to a certain amount per account owner, account type, and institution.

Modern banking and the FDIC

If this is the first time you’ve heard the bank may not have all of everyone’s money on deposit at all times, welcome to modern banking. This system often receives criticism for contributing to financial instability during crisis periods.

Financial instability occurs primarily when consumers get nervous about the safety of their money. A nervous consumer wants to protect their assets from the risk of loss. With enough level of concern, they decide to withdraw their money from the bank. This also has a multiplying effect if more and more consumers also take this action as a precaution. Nothing attracts a crowd like a crowd.

But, we are in the modern banking era. A classic run on the bank is less likely to occur by way of standing in line outside the local branch. A run on the bank now happens electronically. It’s much more swift and significantly harder to control once it begins. This is part of the SVB story.

How FDIC works when banks fail

Did you know: Since 2009, there have been a total of 513 bank failures in the United States.

513.

Did you hear about any of those? Can you name one that failed between 2009 and 2019? There were no bank failures in 2021 or 2022. There have been 2 in the US so far in 2023.

See a full list of failed banks since 2009 here.

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Google searches on FDIC insurance have increased as of late. Why? One public bank failure prompts concerns about the rest of the system. In the case of SVB, the FDIC stepped in to take over the bank and insure deposited funds well above the $250,000 limits.

As soon as a bank fails, the FDIC estimates how much that bank failure will cost the Deposit Insurance Fund (DIF). According to the FDIC, quarterly assessments on FDIC-insured banks fund most of the DIF. A good primer on the program can be found here.

One primary question now: how well-funded is the DIF? More than 85% of SVB’s deposits did not qualify for FDIC insurance. Yet, the FDIC, US Treasury, and the Fed have guaranteed all funds. Will this potentially prevent certain banks from having full coverage? Treasury Secretary Janet Yellen says it might, but vows to protect smaller banks if needed.

Why are banks failing now

Banks fail for a variety of reasons. Banking failures in 2023 may bring back memories of those in 2007-2009. A constant news cycle and social media has a tendency to make conditions feel worse than what may be real.

The FDIC program is a relevant factor in the 2023 bank failures. Another highly relevant factor is Federal Reserve monetary policy decisions.

Monetary policy has been aggressive since March of 2022. The fed funds rate increased from 0.0%-0.25% to 4.75%-5.00% in just 12 months. Cash management has become a conundrum for banks and consumers. Morningstar estimates that more than $460 billion has flowed into money funds since mid-March 2022. It stands to reason some of these funds came from idle cash in bank accounts.

Cash management conundrum

Cash management is a crucial function of wealth management, and a crucial function of the reserve banking system. Simply stated, cash management implies how well cash is positioned to earn yield from various sources. Rates have been so low for so long that cash and equivalents have not earned much yield.

Savings yields at banks have remained low while yields on short-term Treasury Bills and Notes, as well as CDs, have increased. If a depositor is earning 3% on a high yield bank savings account but can earn roughly 5% on Treasuries and CDs through their brokerage firm, guess where the money is going?

This is a problem for banks. With long-term borrowing rates as high as they are, banks may struggle to lend at a profitable volume. Now that short-term yields as high as they are, banks struggle to keep depositors from pulling money to invest elsewhere.

But this isn’t the only issue. The other issue is how the banks themselves operate cash management. Not only in lending long-term, but also in how the short-term money gets invested. Much of SVB’s reserve portfolio was invested in 10 year Treasury bonds. Seems prudent; however, because bond prices fall when yields rise, the bank was sitting on a large unrealized loss. To shore up liquidity, these bonds may be sell a loss. Some of the bonds must be held to maturity.

Lending long and borrowing short creates liquidity risk for banks.

Is your money safe at your bank?

Yes. Most likely.

Legislation coming out of Great Financial Crisis brought better regulation for banks and investment firms. This has led to a decrease in morale hazard and trading of toxic assets. FDIC insurance increased from $100,000 to $250,000. Most customers at most banks do not have enough on deposit to breach the FDIC limits.

Have concerns about your banking and cash management strategy? We can help you better understand your FDIC coverage and ensure your cash is best positioned for safety and yield.

Contact us to learn more.

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Author: Dale Shafer II, CFP®, APMA®, CDFA®

The National Association of Personal Financial Advisors
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