Serious question. What is the least moronic rationale you know of for why the system of deposit insurance in the US has a cap of $250,000?
It is the nature of a lot of government policies that they start out as a proposed solution to a narrow problem. Then, they either fail to solve that problem, or they solve it so well that it threatens the viability of the jobs the program creates. But in either case, new rationales spring up, usually which the policy achieves increasingly poorly. In the end, you get a solution in search of new problems, but the solution itself never goes away.
At first, we had to go to Afghanistan to kill those bastards who blew up our buildings. Then when we had only limited success in that, because said bastards were quite hard to find, we had to go there to blow up the Taliban, who supported the guys who blew up our buildings, and implicitly the Afghans who supported them. Then we had to stay there to fight terrorism in Afghanistan so we didn't have to fight it in New York. Then we had to stay there to liberate the poor Afghans from the Taliban, and impose women's rights and gay rights on goat herders in the mountains. At some point, nobody knew why the hell we were there, and Joe Biden's few cogent thoughts managed to steel enough resolve to finally get America out, albeit chaotically and humiliatingly.
Similarly, in the 1960s, we needed affirmative action because blacks were already as competent as whites, and only hostile, taste-based discrimination was keeping them out. Then when that didn't seem to be true on the test scores, we needed to get the first generation of black leaders in as role models for the younger generation to study hard earlier on, so they could see that they would also be able to be doctors and engineers, at which point it wouldn't be necessary. (Hilariously, Sandra Day O'Connor in Grutter v Bollinger actually committed to this principle and put a time line on it - by 2028, it won't be necessary!) Then once that had gone on for a generation, and the test scores still weren't budging, we decided that actually having more blacks in these places was actually an end in itself. Unlike the Afghanistan War, this one shows no signs of going away.
Deposit insurance has a similar flavor. It is still around, and bigger than ever. But the reasons why keep changing over time.
Which is to say, there is not much mystery as to why originally there was a limit on account size. The original idea was that bank runs were just a fact of life, and when they happened, we wanted to make sure that small depositors were protected and didn't lose their life savings. But since nobody was much interested in protecting fat cats with enormous amounts of cash, they weren't covered.
Over time, instead the idea (cemented in Diamond Dybvig 1983) was that deposit insurance was actually important for preventing bank runs. At this point, you might already be starting to wonder whether the cap makes sense. Are there enough large depositors who aren't insured to cause a run? If there are, then suddenly the cap just looks counterproductive. This is especially so since the stated claim (not unreasonably) is that deposit insurance is actually much cheaper in practice than the size of the guarantee, because in equilibrium you don't actually need to pay out the guarantee if you prevent the run. Of course, the massive regulatory apparatus needed to manage the moral hazard created by the guarantee is far from free, but you're already paying that anyway, regardless of what the cap is. But we're still on the idea that the purpose here is protecting the depositors. Maybe the big guys don't get it, and we end up with some costs we didn't need to have, but too bad. We're not here to bail out fat cats.
By 2008 in particular, the rationale had shifted again - we need to prevent bank runs not because they're bad for depositors (thought they are), but because they're bad for everyone else. Financial crises lead to reductions in the money supply (like in the depression, in the Milton Friedman description), and lead to large asset price declines, and both lead to reductions in real economic activity. We need to make sure that these don't occur - ex ante, we implement deposit insurance and regulation to prevent runs from happening, and ex post we grumblingly bail out systemically important financial institutions if they go under anyway.
Of course, this new rationale is enormously larger and different in scope than what came before. The list of institutions where investors may have a run is basically anyone dependent on overnight financing, even if they're not a standard commercial bank. Bear Stearns. The Reserve Primary Fund. Lehman Brothers. AIG. And each one that goes down increases the likelihood of chaos elsewhere, even among places like AIG that didn't seem primarily dependent on overnight financing (but had sold credit default swaps to institutions who were). The Fed didn't seem happy about the implications of this. Are they suddenly guaranteeing everybody, everywhere? No, they said. No more bailouts. This policy was announced with Lehman's bankruptcy on the Monday. The policy lasted two days. AIG, which had written credit default swaps on Lehman, was now toast. If they'd gone down, Goldman and Citibank would have been next. So bailouts it was.
But now you see the problem (especially for values of "you" that includes crypto institutions). Deposit insurance was brought in originally as something that was a reluctant admission to the demands of grateful depositors clamoring for protection. It eventually morphed into something you can't avoid even if you want to. If there's any chance you might have contagion to anything, anywhere, well now you're going to be regulated, notionally for your own good, perhaps for everyone else's good, but assuredly, because every bureaucracy wants to grow its power and influence.
Parenthetically, I have a friend involved in a bank startup outside the US. I once asked him: "Do you ever think about how much easier it would be to run your entire bank using Tether or USDC, and base it in Yemen or Singapore, as long as you could just get a letter from the United States Government promising to leave you alone?"
His answer: "Every single day."
But, of course, like the schizophrenia of Afghanistan policy where we were simultaneously trying to punish and save the Afghan people, the strange carveout exception for depositors over $250K is still there, just hanging in the breeze. It's now one of the proximate causes of Silicon Valley Bank going bankrupt. Like nearly every bank run, the line between solvency and liquidity is blurry. The post mortems emphasize their unusual exposure to interest rate risk. If your risk management strategy is "assume the Fed will never meaningfully raise interest rates" ... well, actually, that was a disturbingly good bet for a very long time, until one day it wasn't. Still, don't let this distract you from the additional cause. Whatever problems this would have had, if you didn't have ~80% of depositors being above the FDIC limit, and thus uninsured, you wouldn't have had the run play out in the same way, and may not have had it at all.
Janet Yellen couldn't make up her mind. Like the "no bailouts" policy, on the Sunday morning shows she was saying that large depositors wouldn't be protected. Whoops. That policy lasted about 8 hours. By the evening, they were.
And even before this, you'd had these sob stories about how all these hard working startups were totally boned because they'd held their money in SVB. While it's easy to enjoy the schadenfreude of the supposedly brightest investors like Y Combinator reduced to writing petitions begging the Feds for a bailout, there is an actual point here. You can't plan to make payroll each month in any serious-sized firm while holding less than $250K in cash. You can try to minimize the size of your exposure by holding larger amounts in treasuries or money market funds or something, but still, there's going to be a fair bit of straight cash that you need to leave on hand one way or the other, for some large fraction of days. Is it desired policy that these guys just have to eat the bank run risk of wherever they end up? Apparently it is, kinda sorta, unless we change our minds ex post.
Why is all this so bizarre?
Because bank runs are a solved problem even without deposit insurance!
Well, at least for the version of the bank run problem of "where can you safely store your money without the risk of it being lost or stolen, and not have that institution at risk of collapsing on you?"
In the modern world, your bank has an account with the Fed. You give your money to Citibank. Citibank deposits that money at the Fed. The Fed pays Citibank interest on those reserves. Citibank pays you approximately nothing. To which you might ask - can I just put my money in the Fed directly and earn that interest? No, of course you can't. And a bunch of creative finance types tried for the next best thing - they tried to create something called a narrow bank, whose only purpose is to take your money, give it to the Fed, and pass on nearly all the interest to you. What happened? The Fed repeatedly denied those licenses.
You may think I'm exaggerating, or being conspiratorial here. But here's John Cochrane, neither a fool nor a conspiracy theorist, saying much the same thing.
So why do they do it? Well, there's a few answers.
One is that the Fed is effectively captured by the big banks. They like the subsidies from interest on reserves. They like too big to fail. They like the fact that you don't have anywhere else you can stick your deposits, and instead you have to give it to them if you just want the lowest chance of losing your money. You may not like it, but that's why you're nobody, and they're Goldman Sachs.
The charitable explanation, which actually overlaps with the first but gives it a more positive veneer, is that this is actually a tool of monetary policy - we want the fact that your deposits get lent out to small businesses and home buyers, because this expands the money supply, keeps interest rates low, and keeps the economy growing. We don't want you depositing your money with the Fed to just sit there going nowhere. We presumably also don't want the Fed to then have to get into the business of lending the money out directly. Although you may start to wonder why not - we regulate so much else of the lending process, but perhaps it would be a little embarrassing to go mask-off and just have the Fed lend to everyone directly. It would also hurt the shareholders of the big banks - see the previous explanation.
Now, the first thing to question is whether we really have exhausted the range of possibilities - either a) subsidize Citibank and deny narrow banking licenses or b) money supply collapse and economic catastrophe. Are we sure that there is absolutely no other alternative? Bueller?
But hell, let's be charitable and assume that this really is the whole action space. We're crowbarring people into having their deposits be needlessly risky to keep lending flowing and the economy growing, but in return we protect them from bank runs ... unless they hold more than $250K. If they do, stiff shit! Why is that, under the current reasoning? Herp a derp, great question.
Of course, in practice, they'll still probably bail them out ex-post, for the same reason they bailed out AIG. They'll just do it it randomly in an ex-post manner that creates lots of uncertainty, sometimes doesn't materialize (like Lehman), and sometimes creates needless bank runs (like this week).
If you were Doug Diamond, pondering your legacy, it would be disturbing to wonder whether the deposit insurance idea, which actually isn't a terrible one, could turn into something so cumbersome and kafka-esque. But here we are.
So let's clarify the question at the start to make it more damning. What is the least moronic explanation you can come up with for why deposit insurance has a limit of $250K, and the Fed repeatedly denies licenses to narrow banks?
I'm not holding my breath for an answer.
There is a kind of reverse Gell-Mann Amnesia effect of government policy. Everyone looks at the chaos and inefficiency of government in general, and just assumes that policy is likely to be a shitshow run by clowns. But in the area where you personally have expertise, and especially if you have any conceit of being able to influence policy, you see all sorts of sophisticated rationales for why it might actually make great sense and be a clever balancing of tradeoffs.
Now, maybe this is actually the right take, and government everywhere is more sensible than you think. But the alternative is worth pondering. If you have some expertise, and still it doesn't seem to make sense, maybe the general perspective is right. Maybe it is just a dumb, historically accidental clownshow. Even if it's the thing you study. Maybe this is true more broadly, and your expertise mostly leads to rationalization.
The Fed, it is worth noting, is one of the less incompetent bits of the government. They still hire mostly high IQ economists with PhDs from top institutions. This doesn't mean that their assumptions about the world are right, or beneficial, but in general they aren't fools. There are some affirmative action midwits like Lisa Cook, but they are the exception, not the rule. In any case, the Fed is almost shockingly non-partisan. It would be very easy for them to massively jack up interest rates two weeks before the 2020 election to throw things into chaos to get Trump booted out. But they didn't, and they never have. However bad you think current policy is, it could be much, much worse. It probably will get much worse.
And yet. The external position has a fair amount to recommend. We can see some part of policy that seems crazy, arbitrary, and historically anachronistic. What we are left to haggle over is how much this is tip, and how much this is iceberg.
