Most Americans probably don’t care who runs the deposit insurance system as long as their money remains protected from bank failures. Some of us may care about who pays for it, and what kinds of deposits will be protected and which won’t. For state and local treasurers and their constituencies, it gets more complicated.
Deposit insurance for states and municipalities has two key dimensions, one of them “direct” and the other “indirect.” The direct issue for all of them is how FDIC insures their transaction accounts — where they cover payroll and accounts payable — and how the agency insures their interest-bearing investments, primarily in the form of certificates of deposit.
The transaction accounts are typically limited to one or two core depositories, whereas in the CD market it is commonplace for treasurers to spread their money around to multiple banks based on which offers the highest return at any point in time. The rest of their investment portfolios are typically allocated to U.S. government and agency securities, commercial paper and other money market instruments. The larger the portfolio, the less important are CDs and FDIC insurance on bank-issued investments.
The “indirect” dimension of deposit insurance is the value of public deposits to local community banks that often rely on these taxpayer-provided funds for part of their core deposit base from which they make loans. Although local municipal deposits are usually a small part of that overall picture, it’s an important aspect of the public funds landscape and often a cornerstone of community banking and therefore the local economy.
But first things first. The most important concern that public treasurers should be focused on nowadays is their transaction deposit insurance. That’s where bank failures like 2023’s Silicon Valley Bank (SVB) collapse can wreak havoc. Fortunately for public treasurers in many states, there is a patchwork of deposit collateralization laws and state banking regulations that provide a front-line protection if a bank fails. These public depositories are required by law and state banking regulations to hold enough collateral like U.S. Treasury bonds to pay off the public agencies before their assets are carved up by a failing entity’s FDIC foreclosure and resolution teams.
To the extent that deposit collateral is not required by state or local law, then FDIC insurance comes into play. But as with retail investors, there is a limit on that insurance, presently $250,000 per depositor, so that even midsize public agencies with more than 150 employees that lack collateralization requirements can have exposure when a bank fails and they have more than that in their payroll account.
‘Targeted Coverage’
It’s this under-insurance for transitory cash that keeps some public treasurers awake at night — at least whenever they get word that a local bank is in distress. They are not alone: Corporate treasurers and investment partnership accounts all have the same risk. That’s how bank runs get started. The SVB fiasco was bad enough that the Federal Reserve had to step in to provide secondary reserves to a number of other regional banks to prevent a potential national banking crisis.
So when FDIC insurance comes up again for regulatory reviews, job No. 1 for public treasurers should be a laser focus on transaction accounts as the highest priority for expanded FDIC limits. This is not an issue unique to states and municipalities, and there is a common interest for all Americans in bolstering the deposit insurance system to avoid what are called “systemic” losses by innocent depositors who are running a business or government operation and just happen to have cash on deposit when the music stops in an opaque game of musical chairs.
The FDIC has already looked into this, and there is internal staff support for the concept. It’s called “targeted coverage” and should be the top priority of public treasurers.
Providing unlimited deposit insurance for public agency transaction accounts should be a no-brainer. They are a modest fraction of the total deposits in the national banking system, and a single bank’s exposure is generally not going to require loftier nationwide assessments on other banks to cover those losses. Whether private companies should similarly get protection for more than perhaps $1 million in transaction accounts is a fair policy question, but the governmental community can leave that issue to others to solve. The regulations should be written to require that no interest is payable on transaction accounts that enjoy unlimited or expanded FDIC insurance since they are, after all, intended for immediate disbursements and not longer-term investments. Treasurers and their bankers can’t have their cake and eat it too.
A Fresh Look at CD Insurance
This takes us to the investment-like CD market. Here, a case can be made for keeping the $250,000 deposit insurance limits or only expanding them modestly for public agencies. After all, their treasurers and cash managers have ample, ultra-safe alternatives like Treasury bills and notes, their state and local investment pools, and other money market instruments. That said, one defensible exception would be to allow additional FDIC insurance on interest-bearing municipal deposits at banks with facilities within the investing jurisdictions’ boundaries. Such a provision would help smaller local community banks and squarely addresses the “indirect” dimension of deposit insurance — its value in enabling local loans to be supported by public-sector investment deposits.
In any event, the FDIC needs to curb those “hot-money deposits” that are facilitated by CD brokerage firms offering a marketplace platform for investors who want to place more than $250,000 at high interest rates with FDIC insurance on every dollar, which the brokers secure by spreading an investor’s money over multiple banks. That’s a problem that needs fixing. The brokered CD business feeds on lazy money from oblivious investors — including some smaller-portfolio municipal treasurers — who seek higher-than-normal interest rates without any concern for an issuing bank’s financial condition. Heads they win, tails the FDIC loses. It’s a racket.
Today’s FDIC leadership has announced that the agency is dropping its 2024 plans to change regulations for deposit brokers. For now, that’s just as well, because the pending proposals were insufficient to address the real problem anyway. The agency’s leaders need to revisit the relationship between brokered hot money and bank failures, which is one of three factors — the other two being asset-liability maturity mismatches and loan overconcentration in underwater industries like commercial real estate. Last year’s public comments on this issue mostly missed the mark.
The brokers are exploiting the FDIC system’s insurance limits, and the public funds community should stand up and denounce the practice in exchange for getting unlimited insurance on non-interest-bearing transaction accounts. It may be impossible to outlaw brokered CDs, but a reduced FDIC limit of perhaps $100,000 per brokered bank would be a wiser federal policy and a fair tradeoff for unlimited insurance on transaction balances.
For whatever reason, the initial noise about an FDIC shakeup has been paused, which gives public treasurers and the governmental finance community a quick moment to align their strategies in time to secure helpful and durable FDIC reforms. It’s both unrealistic and risky to think that the FDIC system will remain untouched under the new administration. Focus on what matters most and be ready to strike while the iron is hot.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.
