McKernan Underscores Problems With FDIC’s Systemic Risk Exception

In the last few weeks, federal officials have released a flurry of reports and statements related to the Silicon Valley Bank and Signature Bank failures. There’s no shortage of interesting information in those documents, but so far there’s only one that rises to the level of must-read.

Hands down, that title goes to the May 11 statement released by Federal Deposit Insurance Corporation board member Jonathan McKernan.

For starters, the statement provides little-reported background information on the systemic risk exception, the move that enabled the FDIC to cover uninsured depositors as SVB and Signature were failing. This information, by itself, should be enough to make Congress realize how badly it needs to fix the Federal Deposit Insurance Act.

But his statement also clarifies exactly what the systemic risk exception authorizes the FDIC to do, a topic on which the Biden administration has been ambiguous. It also reinforces how counterproductive and duplicative the federal framework has become.

As his statement points out, there seems to be a great deal of confusion over exactly what the systemic risk exception does. It does provide a critical legal exception that allowed the FDIC to cover certain uninsured deposits, but it does not authorize the FDIC to broadly guarantee uninsured bank deposits.

To clarify: the FDIC has a general requirement to close failed banks in a manner that exposes the Deposit Insurance Fund to the lowest possible cost. But the systemic risk exception allows the FDIC to do ignore that requirement for the bank it is closing. Specifically, it allows the FDIC to “take other action or provide assistance” to avoid “serious adverse effects on economic conditions or financial stability.” But only for a bank it is placing in receivership.

So, in the case of SVB and Signature, the systemic risk exception allowed the FDIC to cover uninsured depositors at those two banks. But it did not allow the FDIC to cover uninsured deposits – or anything else – at other banks. In fact, the Dodd-Frank Act explicitly prohibited such guarantees.

Still, these facts did not stop the Biden administration from making it seem all uninsured deposits in the banking system would be covered.

On March 12, President Biden himself said the American people and American businesses “can have confidence that their bank deposits will be there when they need them.” This same language showed up again on May 1, when Press Secretary Karine Jean-Pierre said “the American people and American businesses” could be confident “that their deposits will be there if they need them.” (Treasury Secretary Yellen chose her words more carefully.)

Whatever the intent, the White House also managed to undercut the justification for the systemic risk exception. Jean-Pierre assured the press corps that SVB, Signature, and even First Republic bank, “each faced unique — very, very unique vulnerabilities.” But if those vulnerabilities were, in fact, so unique, it’s very difficult to also argue their failures would lead to “serious adverse effects on economic conditions or financial stability.”

Regardless, McKernan’s statement makes it clear that he voted to exempt the resolutions of Signature and SVB from the least cost requirement – that is, he voted for the systemic risk exception – because he felt it was the only way to “preserve their operations and franchise value.” In other words, McKernan believed that unless the FDIC covered the uninsured deposits at these banks, it would be virtually impossible to sell the failed banks as a going concern.

That’s certainly a debatable proposition, but it does draws attention to at least one serious contradiction in U.S. banking law: Maintaining financial stability conflicts with shutting down banks, even when they’re insolvent.

By design, the systemic risk exception gives federal regulators – and Congress – a pass on the least cost resolution requirement. Ironically, the exception makes it more likely the bank will be kept open in the name of keeping “the system” running, which is the exact problem that Congress was ostensibly addressing with the least cost requirement in the first place.

For many years, the fear that a bank failure could freeze a large number of customer deposits, thus disrupting the economy, has been a main contributing factor to the existing FDIC bank-resolution process and the Fed’s lender of last resort function. But that fear seems to have morphed into the fear that freezing any deposits would disrupt the economy. And without a clear definition of financial stability, the systemic risk exception is easy to invoke.

As a result, the FDIC chose against liquidating SVB even though selling off the bank’s securities portfolio would have paid off all the insured depositors in full.

Selling the $100 billion (plus) portfolio, even with the losses from recent interest rate increases, would have covered the $18 billion insured deposits nearly five times over. And as the FDIC’s own report explains, uninsured depositors historically lose money when banks fail – almost a 25 percent haircut prior to the 2008 financial crisis. (See page 26.)

It’s tempting to suggest Congress should provide structure and accountability to the systemic risk exception, but it’s more sensible for Congress to get rid of it. It simply isn’t the case that resolving a failed bank, no matter how large, means all the money in the bank gets frozen and then disappears. It does not have to result in a major economic disruption.

Besides, with the Fed providing liquidity to the banking system, it’s even harder to make a case that a single bank’s failure would cause widespread economic damage.

On top of everything else, the incentives for the systemic risk exception are all wrong. Nobody at the FDIC, the Fed, or Treasury wants to be the person who didn’t do more to stop some kind of economic disaster. Nobody should be put in that position.