The FDIC Should Act Like a Real Insurer

Deposit insurance is foundational to the American financial sector. In our fractional reserve system, banks lend out nearly all deposits. If depositors all show up demanding their money at the same time, there isn’t going to be enough on hand to satisfy everyone. Even a rumor could start a run, particularly given how quickly ideas can spread in the Twitter age.

Insuring bank deposits makes runs less likely by providing covered depositors peace of mind. But many depositors hold funds in excess of the FDIC’s deposit insurance limit. Businesses, in particular, will often need to keep more than $250,000 in a bank at any one time to meet payroll and pay other bills. If their bank seems unsteady, these depositors have every incentive to pull their money out.

This is what happened to Silicon Valley Bank. The media amplified data that implied more than 90% of SVB deposits were uninsured; business perceived a high risk and ran, pulling $42 billion out in a single day. The FDIC took over and decided to cover all deposits anyway, but making that the rule would absolve banks of almost all responsibility to minimize risks.

There’s a simpler, safer fix. The FDIC should encourage—or require—banks to spread the amount of money they hold in excess of insurance limits among other institutions. Suppose Jane deposits $500,000 at Regional Bank A and Joe puts $500,000 into Regional Bank B. If the FDIC had a system in which Bank A exchanged half of Jane’s deposits for half of Joe’s, it would eliminate any uninsured risk to both customers at no increased risk or meaningful cost to either bank. And all while allowing Jane and Joe to access their funds from their primary bank using their existing debit cards and checkbooks.

The FDIC wouldn’t have to start from scratch to construct such a system. Several large firms and a few fintech startups already help depositors increase their FDIC coverage by spreading their deposit across multiple FDIC-insured banks—referred to as “sweep” or “reciprocal deposit” arrangements. The problem is that few people know about these systems or take advantage of them.

In fact, there are already many ways depositors can get more than $250,000 insured under existing FDIC rules. That cap applies only per depositor per ownership category—customers get $250,000 for each of the 14 types of accounts they can hold at a bank, and if there are multiple account beneficiaries, they each get that much. A married couple could get as much as $1 million covered by dividing their money into separate accounts for each spouse and a shared joint account. This complexity of joint accounts and pass-through insurance likely meant that SVB actually had far more insured deposits than reports claimed. Unfortunately, few people know about these aspects of deposit insurance.

This is where the FDIC can step in. It has unique visibility into the deposits, their composition, and their insurance status at all of the 4,237 banks it covers. The FDIC knows when depositors and banks could benefit from spreading funds in a reciprocal deposit arrangement. It could encourage banks to use these practices by setting a threshold of uninsured deposits over which institutions would have to pay higher premiums unless they use reciprocal deposit arrangements to lower their risk. If the FDIC wanted to take a sterner hand, it could build reciprocal deposit arrangements into its supervisory expectations for risk management. Banks that failed to use the available tools for reducing uninsured deposits would face enforcement actions.

This approach is vastly preferable to increasing the deposit insurance limit or erasing it, which would rack up moral hazard and costs to taxpayers. Plus, the FDIC would eliminate any need for bank bailouts. And it would give regional banks, which provide important local services and spread risk throughout the system, a fighting chance.

Regulators usually resort to tried-and-true tools, regardless of whether they have been successful in the past. Perhaps this time it’s worth trying something different.

Mr. Brooks is a former acting comptroller of the currency and member of the FDIC board of directors. Mr. Henderson is a law professor at the University of Chicago and a visiting fellow at the Hoover Institution.