Bank Failures: The FDIC’s Systemic Risk Exception

Bank Failures: The FDIC’s Systemic Risk Exception

Updated April 23, 2024
Bank Failures: The FDIC’s Systemic Risk Exception
When Silicon Valley Bank (SVB) and Signature Bank
Under the 1991 law, LCR can be waived under the systemic
failed, the Treasury Secretary, the Federal Deposit
risk exception with five statutory requirements: (1) The
Insurance Corporation (FDIC), and the Federal Reserve
Treasury Secretary, in consultation with the President and
(Fed) announced on March 12, 2023, that the FDIC would
upon a written recommendation of at least two-thirds of the
guarantee uninsured deposits at those banks under the
boards of the FDIC and Fed, determines LCR “would have
statutory systemic risk exception to least-cost resolution
serious adverse effects on economic conditions or financial
(LCR; 12 U.S.C. §1823(c)(4)(G)). The FDIC insures
stability” and the FDIC’s actions would avoid or mitigate
deposits up to a statutory limit of $250,000. Currently, the
those effects. (2) Any loss to the FDIC must be repaid
FDIC projects that guaranteeing the uninsured deposits will
through a special assessment on banks by the FDIC. In
cost the FDIC $16.3 billion. Under LCR, losses equal to
levying this assessment, the FDIC need not follow normal
that amount would have been borne by uninsured
deposit insurance assessment rates and may consider who
depositors. The two banks’ combined estimated uninsured
benefited from the action and the effects on the banking
deposits were $231.1 billion in 2022. H.R. 4116, as ordered
industry (as amended by P.L. 111-22). (In this case, the
to be reported in the nature of a substitute in April 2024,
FDIC levied the assessment on the 114 banks with over $5
would require the failed banks’ regulator to report to
billion in uninsured deposits.) (3) The Treasury Secretary
Congress on supervision of the banks and would expand the
must document the decision. (4) GAO must review the
scope of review by the Government Accountability Office
incident. (GAO released its review in April 2023.) (5) The
(GAO) when the systemic risk exception is invoked.
Treasury Secretary must notify the congressional
committees of jurisdiction within three days.
FDIC Least-Cost Resolution
When a bank fails, it does not enter the bankruptcy process
Before 1991, the FDIC considered several goals, including
like other businesses to resolve creditors’ claims. Instead, it
cost, in determining how to deal with a troubled bank. As
is taken into receivership by the FDIC, which takes control
such, LCR, even with the exception, represents a constraint
of the bank and resolves it through an administrative
on its pre-1991 authority. The FDIC can take a number of
process. Costs to the FDIC associated with a resolution are
actions under the exception, but it can be used only in an
funded by drawing on the FDIC’s Deposit Insurance Fund,
FDIC receivership.
which is funded through assessments on banks and backed
by the U.S. Treasury.
Previous Uses of the Exception
Before 2023, GAO reported five planned uses of the
A banking crisis in the 1980s was more costly to the FDIC,
systemic risk exception since 1991, all occurring between
and ultimately the taxpayer, because of the frequent use of
September 2008 (in the depths of the financial crisis) and
regulatory forbearance—allowing troubled banks to stay
March 2009.
open—which in many cases increased the losses that they
suffered before they were ultimately shut down. In some
1. Wachovia. The FDIC sought a buyer to prevent the
cases, the FDIC used open bank assistance to provide funds
imminent failure of Wachovia, the fourth-largest U.S.
or guarantees to troubled banks to keep them going rather
bank. Citigroup made an offer to acquire Wachovia
than taking them into receivership.
under which the FDIC would partially guarantee $312
billion of Wachovia’s assets using the systemic risk
Following the crisis, Congress reformed how the FDIC
exception. The FDIC initially accepted this offer but
resolves banks in 1991 (P.L. 102-242). This act introduced
subsequently rejected it in favor of a competing offer
prompt corrective action and LCR requirements as
from Wells Fargo that required no FDIC assistance.
cornerstones of resolution. These two principles are
2. Citigroup. Concerned that Citigroup, the third-largest
intended to minimize resolution costs by ensuring that
U.S. bank, would fail and exacerbate the financial
banks are resolved as quickly and inexpensively as
crisis, policymakers decided to provide an assistance
possible. As such, uninsured depositors and other creditors
package involving the Fed, the FDIC, and the Troubled
can be repaid in a resolution only insofar as it is consistent
Asset Relief Program (TARP). As part of this package,
with LCR, unless the systemic risk exception is invoked.
the FDIC used its systemic risk exception to provide
What Is the Systemic Risk Exception?
open bank assistance in the form of a partial asset
guarantee for $306 billion of Citigroup’s assets. This
Systemic risk is financial market risk that poses a threat to
guarantee (joint with the Fed and TARP) never paid
financial stability. In the case of SVB and Signature,
out, and the government received compensation in the
policymakers were concerned that a run by uninsured
form of stock and warrants.
depositors would spread to other banks, causing a broader
3. Bank of America. A similar partial asset guarantee for
financial crisis detrimental to the real economy.
$118 billion of assets was offered to Bank of America,
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Bank Failures: The FDIC’s Systemic Risk Exception
the second-largest bank, for similar reasons but was
Policymakers may have “itchy trigger fingers” and
never finalized. Bank of America paid the government
intervene before the need has been proven. In this case, the
a termination fee to cancel the guarantee when
failure of two mid-sized banks, in isolation, posed little risk
financial market conditions stabilized. Unlike with
to the economy or financial system. It may be that other
Wachovia and Citigroup, the exception was invoked in
banks could have fended off the pressure of withdrawals on
anticipation of market pressure on Bank of America
their own and conditions could have stabilized.
before it occurred.
4. FDIC’s Temporary Liquidity Guarantee Program.
The downside to intervening is the cost to the government
To help banks remain liquid during the financial crisis,
and moral hazard—the concept that when individuals or
the FDIC created this two-part temporary program—
businesses are protected from losses they will act more
the Debt Guarantee Program (DGP) and the
recklessly. In this case, SVB and Signature and their
Transaction Account Guarantee Program (TAG). Both
leadership and shareholders were not “bailed out,” as the
programs were voluntary but automatic unless banks
banks were closed, but uninsured depositors were. Congress
opted out. Under DGP, the FDIC guaranteed certain
set a deposit insurance limit in part because there is an
debt issued by banks between October 2008 and
expectation that depositors above the limit should be
October 2009. Under TAG, the FDIC guaranteed non-
financially sophisticated enough to monitor their banks’
interest-bearing deposit accounts (primarily owned by
riskiness (i.e., impose market discipline). By using the
businesses and local governments) above the deposit
systemic risk exception, policymakers have signaled that
limit. Both programs charged participating banks fees
banks and their uninsured depositors need be less concerned
to cover potential costs.
about risk taking going forward. (The systemic risk
exception was not used to protect the banks’ debtholders or
5. Public Private Investment Program (PPIP).
shareholders, so debtholders at other banks arguably still
Treasury created the Legacy Loan Program within
TARP’s
have an incentive to monitor risk taking.)
PPIP. Under this program, the FDIC would
have partially guaranteed “legacy loans” acquired by
Guaranteeing uninsured depositors also shifts the costs of
PPIP. The program never progressed beyond a pilot
the resolution to banks that did not fail. In a counterfactual
phase.
where all deposits had been insured, banks including SVB
Of the five cases, only the TAG program resulted in net
and Signature would have pre-funded the deposit insurance
costs to the FDIC. Assistance to Citigroup, Bank of
fund ex ante to a size sufficient to absorb the costs of
America, and the DGP resulted in positive net income to
guaranteeing all deposits. Instead, those costs must be
the FDIC or the government as a whole. (A special
recouped ex post. But the FDIC is required to consider who
assessment was not levied for TAG because its net income
benefited from the intervention when levying assessments.
was considered jointly with the DGP.) In the cases of
Wachovia, Bank of America, and PPIP, the proposed action
A long-standing moral hazard concern is that some banks
never occurred. (See CRS Report R43413, Costs of
are “too big to fail,” meaning that their failure could result
Government Interventions in Response to the Financial
in financial instability, which would result in government
Crisis: A Retrospective.)
bailouts to prevent them. Although SVB and Signature
were taken into receivership, the use of the systemic risk
None of these five episodes involved a bank in FDIC
exception at two institutions that few previously believed
receivership. (Wachovia would have been an FDIC-assisted
were TBTF supports those concerns. In addition to moral
open bank transaction.) Although the exception was clearly
hazard concerns, TBTF could potentially put small banks at
intended to be a bank resolution tool, policymakers used the
a competitive disadvantage if uninsured depositors believe
authority at the time to justify two crisis programs that were
their deposits are safer at large banks because the systemic
open to all banks, including healthy ones. In 2010, the
risk exception would be invoked only for a large bank.
Dodd-Frank Act (P.L. 111-203) limited the systemic risk
exception to receiverships to rule out its future use for
The first use of the systemic risk exception since it was last
broadly based programs. It provided separate authority for
amended in 2010 raises questions about whether additional
future debt guarantee programs and temporary authority for
legislative changes are warranted. Policymakers’ discretion
a TAG program that was not renewed when it expired.
could be narrowed, but it might impede their ability to
Policy Issues
quickly and flexibly respond to a crisis. Nevertheless, the
Dodd-Frank Act added more parameters to the Fed’s
The systemic risk exception is a recognition by Congress
emergency lending authority (12 U.S.C. §343) concerning
that financial stability concerns sometimes trump the desire
when and how that authority should be used—and what
to minimize potential costs to the taxpayer. Financial crises
should be reported to Congress—compared to the FDIC’s
impose economic costs that can far exceed resolution costs
exception. Those changes did not prevent the Fed from
to the FDIC. Because systemic risk is unpredictable and fast
responding aggressively to the COVID-19 pandemic or
moving, emergency tools such as the systemic risk
from creating a new emergency program following the
exception have been crafted to give policymakers broad,
failures of SVB and Signature. Legislative changes to bank
discretionary powers to respond quickly to a range of
regulation or deposit insurance could also change the
potential risks. This way, financial conditions can be
likelihood of the systemic risk exception being used again.
stabilized before a crisis spirals out of control. In this case,
guaranteeing uninsured deposits may have prevented a
Marc Labonte, Specialist in Macroeconomic Policy
broader deposit run that could have caused other banks to
IF12378
fail. Broad, discretionary powers come at a cost, however.
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Bank Failures: The FDIC’s Systemic Risk Exception

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