In 2023, several large banks have been forced by sudden uninsured deposit runs into default or shotgun marriages with large fiscal costs. While all these banks had suffered losses and were insolvent, some were arguably just undercapitalised. Their distress was precipitated by self-reinforcing runs on uninsured deposits, which blackmailed authorities into costly bailouts.
The experience calls for norms aimed at strengthening uninsured deposit stability, specifically to prevent solvent intermediaries from defaulting when withdrawals turn into a self-fulfilling run.
Ex-ante solutions include extending deposit insurance and raising bank capital. Contingent solutions would strengthen risk absorption to prevent run escalation into default. Each of these options affect run incentives by allocating risk, either to taxpayers, investors, or uninsured depositors. The key policy issue is how to allocate risk efficiently while limiting endogenous risk taking.
Ex-ante measures
An extreme option would eliminate risk by narrow deposit banking, a variant of government money market fund. This solution protects basic payment and store of value for savers at the cost of eliminating maturity transformation and intermediation, shifting credit risk where it is least regulated. Arguably we need a more global solution.
A radical option is to suppress runs by wide guarantees for most bank demandable debt, well beyond insured household deposits. This choice suppresses run incentives at the cost of boosting risk incentives and foreshadowing a huge fiscal burden. Ex-post insurance has been justified by imposing ex-post levies on the banking sector; yet late mutualisation of losses only reinforces the negative externality of risk taking. Moreover, the historical experience suggests that public insurance is under-priced, so most default costs are not ultimately borne by the banking sector.
A natural solution is to vastly increase private risk absorption capacity, forcing more bail-in capital so that uninsured depositors are paid even in a default and do not need to run.
Such a large rise in capital standards requires a lengthy legislative process, while many banks still do not satisfy existing total loss absorption capacity (TLAC) norms yet. Until then, even solvent banks and fiscal authorities are at the mercy of self-fulfilling runs, so regulators need new instruments to intervene in sudden distress.
Contingent measures
We focus next on two reforms to strengthen contingent tools to protect bank capital and liquidity, to be activated when the intermediary suffering runs is deemed undercapitalised and solvent.
Going concern bail-in
A solution of bail-in ahead of resolution would create a timely procedure for ‘going concern’ bail-in of contingent convertible (CoCo) debt. A sharp drop in leverage activated upon early signs of distress alleviates
solvency concerns at a critical time, discouraging further outflows.
At present, there is no functional trigger for early conversion, even though CoCo debt is allowed as AT1 core capital. Until the Credit Suisse default, CoCo bonds had converted only in default (gone concern), just like any other bond.
Not even a single coupon has ever been suspended, as regulators have feared triggering panic. As a result, the market did not believe in a going concern trigger.
A credible bail-in procedure requires an enhanced Pillar II mandate to activate conversion, upon a supervisory assessment that the bank is undercapitalised but solvent. A timely reduction in leverage would grant immediate breathing space and remove run incentives. Such a preventive recapitalisation can be seen as a form of in vicem resolutio, a going concern recapitalisation that does not require default.
Swing pricing
A similar procedure would protect bank liquidity upon large runs on uninsured deposits, by regulators activating ‘liquidity pricing’ and possibly modest gates (residual amount at risk). This procedure allows savers and firms to withdraw as needed at a discount to face value.
This approach follows the money market fund reform debate since March 2020. Money market funds (MMFs) had been the main destination for corporate cash pools, so they are a natural benchmark for corporate needs. The early money market fund reforms had focused on slowing down outflow by temporary suspensions. Funds were mandated to impose such gates upon rapid outflows or impose fees to reflect scarce liquidity (swing pricing).
However, in March 2020 money market fund managers proved reluctant to impose gates and rather sold less liquid claims to avoid triggering a mandatory suspension of redemptions. Recent proposals by the Securities and Exchange Commission (SEC) would remove all gates and introduce a robust swing pricing regime in case of runs. Swing pricing serves as a reliable brake on run incentives by pricing illiquidity on withdrawals, protecting those who do not run. Repricing removes run incentives driven by dilution risk, since illiquidity is here fully priced.
Swing pricing may be combined with a limited residual amount at risk (RAR), proposed by Cipriani et al. (2023). Uninsured deposit withdrawals would have a small amount gated, with right to withdraw within a month (at lower seniority to unwithdrawn deposits in case of default).
Both measures are aimed at discouraging the escalation of run incentives that may disrupt a solvent intermediary. Both solutions maintain firm access to liquidity, at a modest price in distress times.
Comparing alternative solutions
Table 1 summarises these options, highlighting how the allocation of risk affects moral hazard and run incentives, trading off liquidity, capital, and fiscal costs.
Table 1 Potential reforms to strengthen deposit stability
Deposit insurance and higher capital have the strongest effects and highest cost, and would face extensive resistance. Interim measures targeted at going concern preservation may be embedded as prompt responses containing the escalation of runs. This calls for solid pre-resolution regulatory powers to activate pricing and gating in response to uninsured runs on banks deemed solvent.
In any run, allowing outflows at par value directly dilutes those who do not withdraw. As a result, once outflows start all depositors have an incentive to run if they expect others to do the same. To de-escalate run incentives it is critical to penalise or slow down rapid outflows.
Such norms already apply to money market fund norms. Money market funds were the main historical destination of corporate cash pools, so they serve as a natural benchmark. Swing pricing and gates maintain access to safe liquidity for businesses without incurring public costs boosted by endogenous risk-taking incentives.
Conclusions
In this column, I have discussed proposals to ensure deposit stability for solvent banks, while protecting public finances and limiting moral hazard. Better capital and liquidity norms are clearly needed.
We advance the notion of a strengthened regime (in vicem resolution) targeting run escalation by appropriate assignment of risk to private parties and effective triggers for going concern bail-in.
A modest (and priced) expansion of deposit insurance for smaller firms may improve safe operational liquidity. But businesses can bear a modest amount of price risk and have done so historically in exchange for a better yield. Deposits serve a primary safety role for households, so household deposit insurance is a legitimate public goal. In times of many demands on fiscal resources, public insurance for corporate cash holdings does not appear a public priority.
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