Depositor Discipline and the Banking Panic of 2023

Introduction

There is a significant body of academic literature supporting the hypothesis that short-term creditors, including uninsured depositors, play a significant role in moderating bankers’ appetite for taking risk. This literature, which mostly predates the Great Financial Crisis, argues that short-term creditors can impose market discipline on banks if they: (1) have the ability to monitor and assesses the risk profile of a bank; and (2) take actions that cause bank management to respond to short-term creditors’ risk assessments (e.g., Calomiris and Kahn, 1991; Flannery 1994, 2001; Bliss and Flannery, 2002).

Short-term creditors are a source of market discipline if they systematically identify risky bank behavior and charge higher interest rates and limit credit to banks with elevated risk profiles. If they do, bank managers must anticipate the inevitability of elevated funding costs when evaluating the profitability of a risky business venture. While it goes untested in this literature, to be effective disciplinarians, short-term bank creditors would not only have to charge higher interest rates, but correctly price a bank’s risk in order to be an efficient source of discipline on banks risk-taking.

For the most part, academic studies have concluded that short-term bank creditors who face losses in the event of bank insolvency charge higher rates and limit their exposures to at-risk banks (see, inter alia, Baer and Brewer, 1986; Park and Peristinni, 1998; Goldberg and Hudgins, 1996, 2002; Hannan and Hanweck, 1988; Cargill, 1989; Keeley, 1990; and Furfine, 2001). These short-term creditors include banks actively participating in the federal funds market and uninsured deposit accounts, including certificates of deposits above the federal deposit insurance limit.

A few studies (e.g., Davenport and McDill, 2006; and Bennett, Hwa and Kwast, 2015) find that fully-insured deposits provide some market discipline. However, these studies are an exception in the literature as the vast majority of studies conclude that deposit insurance eliminates depositor incentives to monitor and discipline banks. Deposit insurance is systematically associated with lower deposits interest rates and increased bank risk taking (see, inter alia, Demirgüç-Kunt and Huizinga, 2004; Anginer, Demirgüç-Kunt and Zhu, 2014; Calomiris and Jaremski, 2016; and Calomiris and Chen, 2022). Recent evidence using high-frequency deposit flow data (Martin, Puri and Ufier, 2022) finds that banks often exploit deposit insurance by raising deposit rates to attract fully-insured deposits to offset outflows of uninsured deposit balances. The availability of a ready supply of insured deposits mitigates any discipline uninsured depositors might otherwise provide.    

While there is academic consensus that uninsured short-term creditors exert market discipline on banks, a lot has changed since many of these studies were published. Some of the changes in the economic environment have removed the incentives some short-term creditors once had to monitor and discipline banks. For example, changes in the Federal Reserve’s monetary policy operating procedures have altered the character of federal funds market, a market which historically had been an important source of short-term creditor discipline in the banking system. More recently, Fed policy actions and Federal government COVID19 stimulus payments caused a dramatic increase the amount of insured and uninsured banking system deposits at a time when the Fed held deposit rates near zero for an extended period. It is unclear whether uninsured depositors can be an effective source of market discipline in a banking system awash in deposit liquidity.

A review of the operations of four banks, Silvergate, Signature, Silicon Valley and First Republic—banks that either failed or voluntarily liquidated during the first half of 2023, shows that their operations were massively dependent on uninsured deposit funding. Uninsured depositors continued to fund the rapid growth of these depositories despite the fact that these banks’ risky investment strategies were observable in publicly available information. In all four cases, uninsured depositor behavior arguably was at odds with the academic literature finding that short-term at-risk creditors are a source of market discipline on bank risk-taking behavior.

In the remaining sections, I discuss the federal funds market and explain how changes in in the way the Federal Reserve implements monetary policy changed the characteristics of the federal funds market. I review the federal government and Federal Reserve policy responses to the COVID19 pandemic and document the influx in banking system deposits created by these policies. I explain the role uninsured deposit funding played in the growth and demise of Silvergate, Signature, Silicon Valley and First Republic Bank. I argue that, despite an almost complete reliance on uninsured deposit funding, uninsured depositors failed to impose market discipline on these banks’ risky business strategies even though the banks’ financial vulnerabilities were, in many cases, visible in publically available regulatory reports. I discuss reasons why uninsured depositors may have been indifferent to these banks’ risk profiles. Finally, I note that uninsured depositors were not unique in their failure to discipline management in these banks—federal and state bank supervisors failed to detect safety and soundness issues and impose the necessary corrective actions. A final section offers concluding remarks.  

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