Deposit Insurance Encourages Bank Failures Like SVB

Silicon Valley Bank’s failure makes many Americans grateful for deposit insurance, which protects accounts holding $250,000 or less. But the SVB episode also illustrates the dangers of deposit insurance. A banking system dominated by government insurance, plus too-big-to-fail protection that effectively insures all deposits at the largest banks, lacks essential market discipline, is systemically unsafe, is more likely to see episodes like SVB’s failure, and is more costly to taxpayers and bank customers.

Historically, unprotected well-informed depositors, especially other banks, gauged and responded to each bank’s risk, creating an incentive for banks to manage risk responsibly. Uninformed depositors—like those now at risk at SVB—were free riders on informed discipline. Now, informed depositors can easily get around the $250,000 limit on insurance, which eliminates their incentive to monitor banks. The recent disappearance of the interbank loan market means that banks don’t monitor each other to gauge creditworthiness as short-term borrowers of reserves either. That leaves only bank regulators to mind the store, and they often lack incentives and knowledge to measure and punish risk on a speedy basis. That’s how predictable messes like SVB happen.