When the Federal Deposit Insurance Corporation (FDIC) assumed control of Silicon Valley Bank and Signature Bank, it did so under a mechanism called the Systemic Risk Exception (SRE), which is designed to enable the FDIC to react to a bank crisis that it feels is putting the entire US banking system at risk. The exception allows the FDIC to make depositors whole, even those with deposits larger than the FDIC’s maximum regular insurance threshold of $250,000.
The SRE has rarely been used, but given recent events, here's a quick primer to shed some light on the history behind the headlines.
Origins The SRE was created by the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), as the national banking crisis of the 1980s was winding down. Around 1,600 banks failed between 1980 and 1994, caused by a confluence of events, among them weak regulation over savings & loan institutions, and a collapse in energy and real estate prices in certain sections of the country.
Backing up a step, the Federal Deposit Insurance Corporation was created by the Glass-Steagall Act of 1933 to insure bank deposits. The insurance started in 1934 at $2,500 per depositor, and today is at $250,000. (Glass-Steagall also famously separated commercial and investment banking and less famously was mostly repealed by the Financial Services Modernization Act of 1999, commonly known as the Gramm-Leach-Bliley Act.)
The FDICIA was implemented to increase the FDIC’s powers. It instituted audit and reporting requirements for banks, ordering “progressively severe, corrective, supervisory actions” as a bank’s capital level declines, according to the St. Louis Federal Reserve Bank.
The act also empowered the FDIC to wind up insolvent banks in a way that, as the act says, “is the least costly to the deposit insurance fund of all possible methods for meeting the [FDIC’s] obligation” to provide insurance coverage for depositors. Known as the “least cost test,” it included whether the choice might be, for instance, to sell the bank as a single entity or liquidate it and sell its assets piecemeal.
Exceptional risk The FDICIA includes an exception to the least cost test. A congressional study done while preparing the legislation noted that “the presence of systemic risk could require a decision to protect uninsured depositors even if it is not the least costly resolution method,” according to the FDIC. This suggested allowing an exemption if complying with the least cost test “would have adverse effects on economic conditions or financial stability,” as described by Federal Reserve General Counsel Scott Alvarez in testimony before Financial Crisis Inquiry Commission in 2010.
Systemic risk is defined in an FDIC working paper as “risk that arises because of the structure of the financial system and interactions between financial institutions.” The paper notes that systemic risk includes systematic risk, which it defines as “risk explained by factors that influence the economy as a whole,” and it includes risks caused by “contagion,” defined as “the transmission of losses or distress from one institution to another.”
The working paper gives two examples of institution-to-institution contagion: "asset price contagion," where, for instance, fire sales by a failing institution force mark-to-market prices down for all other institutions, possibly putting their balance sheets in jeopardy; and “counterparty contagion,” where a transaction’s failing counterparty has a domino effect that negatively impacts other financial institutions.
Implementing SRE In order for the systemic risk exception to be invoked, the FDICIA requires written recommendations from the boards of both the FDIC and the Federal Reserve, with both boards needing the voting approval of two-thirds of their members to make the recommendation. Then the Secretary of the Treasury signs on after consulting the President. Congress must then be notified. All of that happened for the first time roughly 17 years after passage of the legislation, during the Global Financial Crisis.
The exception was first used on Sept. 29, 2008, 14 days after Lehman Brothers filed for bankruptcy protection, to facilitate the sale of Wachovia Corp.’s banking business initially to Citigroup (Wells Fargo & Co. eventually purchased it). A Wachovia insolvency and liquidation using the least cost test would have had “disastrous effects for an already weakened economy,” according to the Federal Reserve’s Alvarez. He added that in a runaway Wachovia failure, “business and household confidence would be undermined by the worsening financial market turmoil, and banking organizations would be less willing to lend due to their increased funding costs and decreased liquidity.”
Two weeks later, the exception was used again to enable the FDIC to provide unlimited coverage for certain non-interest-bearing accounts under the Temporary Liquidity Guarantee Program, which was instituted to “bring stability to financial markets and the banking industry,” according to the FDIC.
The exception was then used for Citigroup itself in January 2009, according to a Government Accountability Office report. The report noted that the exception was considered twice more during the GFC, for Bank of America and for the Public-Private Investment Program, but was not actually used.
The next one Now it has been used again. Not only that, but for the banks still standing, the Federal Reserve on March 12 created the Bank Term Funding Program to give banks, savings associations, and other institutions loans of up to one year “to help assure banks have the ability to meet the needs of all their depositors,” to borrow from the Federal Reserve press release.
Invoking the SRE for Wachovia and Citigroup didn’t stop the Global Financial Crisis. It remains to be seen whether using it for SVB and Signature Bank will have better results.
