How to prevent bank runs? Here's a simple plan that the banks will hate

This solution entails the least amount of regulatory effort, is soundly founded in economic theory and evidence, and eliminates the unlevel playing fields on which large and small banks compete and on which all banks compete with non-bank lenders.  That's why the banks will hate it.

To prevent the bank runs that led to the failures of Silicon Valley Bank, Signature Bank and First Republic Bank, some economists — including myself — recommend that banks segregate their capital and carry sufficient secure short-term liquid assets (T-bills) to cover any potential bank run. Although sound in economic theory, this proposal will be politically challenging to implement in practice.  

So legislators and regulators should discuss other policies, especially proposals to increase bank transparency and thus allow the public to better evaluate bank solvency.  In particular, banks should mark all securities and loans to market. They should not be allowed to continue the common practice of carrying these assets at face value by declaring that they will hold them to maturity. The hold-to-maturity loophole is an accounting abomination that violates basic accounting and finance principles. Instead, timely information about capital ratios based on market values should be readily available to depositors. 

Even with greater transparency, the playing field will still be uneven between the large systemically important banks (“too big to fail”) and all other banks. The Federal Deposit Insurance Corporation's (FDIC) systemic risk exception effectively subsidizes the large banks designated by the Treasury's Financial Stability Oversight Council as systemically important through implicit deposit guarantees not available to the smaller banks. And the FDIC is funding the recent regional bank losses with money raised through bank assessments that ultimately decrease the rates depositors receive on their money.  

The simplest and perhaps most politically expedient way to prevent bank runs is to require that all banks hold more capital. This solution entails the least amount of regulatory effort, is soundly founded in economic theory and evidence and eliminates the unlevel playing fields on which large and small banks compete and on which all banks compete with non-bank lenders.  

But legislators have actually four policy alternatives to address these inequities in the banking system. 

The first would be to stop guaranteeing any deposits.  This alternative is not politically viable, and, as a practical matter, regulators will not adhere to it when large banks fail. 

The second would be to guarantee all deposits.  But such guarantees create moral hazards, because banks often take more risk when their deposits are guaranteed. They reap full rewards when their investments are profitable but share the losses with the guarantor when they fail. These regional banks failed because of moral hazard.  When Treasury bill rates fell to near-zero levels, the only potentially profitable strategy available to them was to roll the dice on long-term interest rates. If the rates did not rise, bank runs would not have occurred, and the banks would have profited. However, rates did rise, the banks failed and the FDIC ultimately picked up the losses. 

Accordingly, deposit guarantors must regulate banks to control these moral hazards.  But regulation is costly and often ineffective, as the recent bank runs demonstrate. Regulatory control has too often failed to prevent bank runs, and no evidence suggests that it will be more successful in the future. Guaranteeing deposits also unfairly subsidizes banking finance by making cheaper money available to the banks, while non-bank lenders operate at a disadvantage.  Accordingly, guaranteeing all bank deposits is an unfair policy solution. 

A third possibility is to require that banks hold sufficient short-term liquid secure assets to cover any potential bank run.  This proposal is attractive because implementation is operationally easy.  But it also faces significant political obstacles. Banks will claim they must increase bank loan interest rates if they cannot loan their depositors’ funds. However, any such increase would be due to elimination of the subsidy implicit in deposit insurance and government guarantees.  This subsidy distorts capital allocation decisions and is unfair to all other financial institutions and individuals who loan money.  

The fourth policy alternative is to require banks to carry so much capital that deposit guarantees will not influence their risk-taking behavior.  Under this proposal, the FDIC could guarantee all deposits because the guarantees would produce little moral hazard. But banks will not like this proposal either. They will claim that increasing required capital ratios will decrease money available for loans. But this argument is specious.  Banks can raise more capital to fund loans that are sound investments. Moreover, well-accepted financial theory and evidence indicate that average capital costs drop when companies have more capital relative to the risk they bear — that is to say, investors accept lower rates of return when their investments are more secure. 

There are actually three reasons banks do not want to hold more capital. First, the expected return on capital drops when banks have more capital for a given level of risk because the benefits of successful bank investments (primarily loans) are spread over more capital. But more capital also means that any losses are more widely shared, which makes the capital less risky and thus more attractive to most investors. Investors seeking higher expected returns can buy bank stocks on margin to obtain more risk for a given dollar investment. 

Second, the lower expected equity returns and volatilities associated with higher capital ratios decrease the values of executive compensation stock options.  Accordingly, bank executives prefer lower capital ratios.   

Finally, and perhaps most importantly, high capital ratios reduce the moral hazard associated with deposit insurance.  When banks are sufficiently capitalized, shareholders, not the FDIC, bear the losses associated with bad investments.  

The banking system’s excessive reliance on deposit insurance to prevent bank runs has created a heads-I-win, tails-you-lose game, with the public playing on the wrong side.  These banking problems must end to facilitate stable long-term growth.  

Larry Harris is a professor of finance and business economics at the University of Southern California Marshall School of Business. He was chief economist of the Securities and Exchange Commission from 2002 to 2004.