This post was authored by Salvatore M. Capizzi, Dunham's Chief Sales & Marketing Officer. If you have questions concerning today's topic, please call us at (858) 964 - 0500. Hold us to higher standards.

Does the Government Help or Hinder Moral Hazard

Have you ever considered how your client's trust in the government could inadvertently fuel risky behavior from them and the very institutions “safeguarding” some of their assets?

As depositors, your clients' confidence in government-backed insurance may inadvertently encourage both them and the institutions where they hold their funds to take on excessive risks, potentially threatening the stability of the entire financial system.

The situation has a name, which I will discuss as soon as I explain why I am writing this article.

It Happened on Friday

On Friday, April 26, 2024, the Federal Deposit Insurance Corp. (FDIC) announced the seizure of the Philadelphia-based Republic Bank. According to the agency, Fulton Bank, headquartered in Lancaster, Pennsylvania, has agreed to take on nearly all failed bank deposits and acquire virtually all of its assets.

Once again, the FDIC has found a bank to take the deposits with no loss to the depositors. There were five bank failures in 2023⁽¹⁾, and Republic Bank was the first in 2024⁽²⁾, all with happy endings. However, caution needs to be exercised. This is where the concept of Moral Hazard steps in.

Moral Hazard for Depositors

For depositors, moral hazard is when they trust that their deposits are fully insured by the FDIC or that the FDIC will arrange for their deposits to be transferred to another bank. This might lead to a sense of security, causing depositors to be less vigilant about their bank's financial health and risk-taking.

Said differently, the belief that all their deposits are protected may incentivize your clients to deposit money in banks with riskier profiles without adequately assessing those associated risks. They believe they will be protected from the negative consequences of their actions.

Just as my love for pizza might lead me to believe that nothing bad will happen if I grab that extra slice despite the potential health risks, moral hazard similarly involves the perception that there are no consequences for taking risky actions, even when adverse outcomes are possible.

Moral Hazard for Banks

On the flip side, banks may yield to moral hazard when they perceive that their actions have limited consequences due to government intervention or bailouts. The expectation of a government rescue in the event of failure leads banks to engage in overly risky practices, such as making loans to borrowers with weak creditworthiness or investing in speculative assets.

Moral Hazard might lead to imprudent risk-taking behavior among executives and employees. When a decision-maker believes they will not bear the full costs of their actions and possibly negative outcomes, they may prioritize short-term gains over long-term stability, ultimately putting the institution and its depositors at risk.

 Adem Tumerkan wrote an outstanding article about the headwinds some banks face today. It is required reading if you want a perspective on this potential crisis developing. You can read it here.

Do Not Panic

Please understand I am not trying to create unnecessary alarm or panic. It is important to provide a fair and balanced perspective. According to MoneyWatch, the likelihood of losing money held at a bank is exceptionally low. They report that less than 7% of bank failures since the beginning of 2007 have resulted in losses for uninsured depositors.⁽³⁾

In my view, 7% is a reassuring number only when it is not your deposit over the FDIC limits that were not covered by FDIC insurance. Based on my research, there have been 567 bank failures since 2001, and 19 banks with no knight in shining armor saving depositors above the insurance limits.⁽⁴⁾

 Imagine being a NextBank depositor and reading this paragraph in the FDIC’s press release about your bank:

The FDIC received no bids for the bank's deposits. As a result, Monday morning the FDIC will mail checks to the customers of the failed bank for the amount of their insured deposits. Customers with more than $100,000 on deposit at the failed bank should contact the FDIC toll-free at 1-877-367-2719 and ask to speak with a claims agent.⁽⁵⁾

Deposit Flight

Furthermore, moral hazard among depositors can lead to what is known as "deposit flight." This may occur in times of financial distress or uncertainty. This is where depositors may hastily withdraw their funds from a bank they perceive as risky, exacerbating the institution's financial woes and potentially triggering a broader crisis.

Banking Crisis of 1980 - 1994

If, like me, you were in the business during the 1980s, you might recall the banking crisis that spanned from 1980 to 1994. The FDIC reports that during this period, 1,617 commercial and savings banks were affected and these institutions held $206.2 billion in assets. It led to the very first operating loss for the FDIC.⁽⁶⁾

The banking crisis spanning from 1980 to 1994 is a glaring reminder of the deep impact of moral hazard on the financial system's stability. This period saw numerous banks give in to risky lending practices and speculative investments, worsened by depositors' belief that all their funds were insulated from loss.

The lesson is that these events do happen and can happen again in the future.

Final Thought

Moral hazard poses a challenge in the banking industry. It affects the behavior of depositors and banks and can potentially undermine financial stability. I fear that with the government stepping in and finding a remedy for the last six bank failures, your clients may become the poster child for moral hazard.

As a client's financial advisor, it is important for you to recognize and address this with your clients who insist on keeping more than $250,000 at a bank. I believe that one day, there may not be a bank willing to take over a failed bank, and the FDIC will not be willing to insure all depositors, even those above the current $250,000 limit.

You do not want your clients to read a press release like the one NextBank depositors received highlighted above.

How The Dunham Insured Marketplace Can Help
Help clients find bank programs that offer multi-millions of FDIC insurance, like the Dunham Insured Deposit Marketplace (IDM). This program has up to $50 million in FDIC Insurance and what we consider a highly competitive APY. It allows your client to spread their deposits among various banks, saving time for them to research and find several banks that will fully protect their banking assets. Learn more by clicking here.

Sources:

(1)    Bank Failure 2023 in Brief, by The FDIC, n/d, https://www.fdic.gov/resources/resolutions/bank-failures/in-brief/bfb2023.html#:~:text=There%20are%205%20bank%20failures,a%20month%20within%20the%20graph.

(2)   Bank Failures in 2024, by The FDIC, n/d https://www.fdic.gov/resources/resolutions/bank-failures/in-brief/bfb2024.html

(3)   Don’t worry too much about losing your bank cash. Bank-failure data don’t support panic over uninsured deposits, by Elanor Laise and Katie Marriner, April 21, 2023, https://www.marketwatch.com/story/dont-worry-too-much-about-losing-your-bank-cash-bank-failure-data-dont-support-panic-over-uninsured-deposits-219fc64

(4)   Bank Failures in Brief – Summary, by The FDIC, n/d, https://www.fdic.gov/resources/resolutions/bank-failures/in-brief/index.html

(5)   FDIC Approves the Payout of Insured Deposits of NextBank, National Association, Phoenix, Arizona, by The FDIC Press Release, February 7, 2002, https://archive.fdic.gov/view/fdic/2217

(6)   Banking Crisis of the 1980s, by John Summa, updated October 6, 2021 https://www.investopedia.com/articles/financial-theory/banking-crisis-1980s.asp#:~:text=According%20to%20the%20FDIC%2C%201%2C617,the%201980s%20and%20early%201990s.&text=The%20cost%20of%20the%20crisis,U.S.%20General%20Accounting%20Office%20estimated.

(1)(7) The Banking Crisis of the 1980s and Early 1990s : Summary and Explanation, by The FDIC, n/d, https://www.fdic.gov › bank › historical › history PDF

Disclosure:

This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance. All examples are hypothetical and are for illustrative purposes only.

If you participate in the IDM offered by Dunham Trust Company (“DTC”), DTC is acting as your agent. DTC also serves as custodian of the Custom Asset Allocation Programs and is an affiliated entity of Dunham & Associates Investment Counsel, Inc., (“DAIC”), a Registered Investment Adviser and Broker/ Dealer. Member FINRA/ SIPC. DAIC is the sponsor of the Dunham Asset Allocation Program.

The FDIC insurance limit for all insurable capacities in the IDM is $250,000 per program bank. The IDM program banks may be excluded from receiving program deposits in the event that total assets at a program bank (including assets that are held with the bank outside of DTC’s IDM) exceed the FDIC insurance limits. For example, if you have deposits in a bank through the program and also have made deposits at that bank outside the program, all of these deposits will count toward the FDIC limit. It is your obligation to monitor your account(s), your FDIC coverage and your FDIC insurance eligibility. See www.fdic.gov for more details regarding FDIC coverage. For more information on DTC’s IDM, please refer to the IDM Disclosure Booklet. If you would like to opt out from certain program banks, please speak to your advisor or contact Dunham at customercare@dunham.com .

Excluding a bank from holding your Insured Bank Deposit balances may result in a lower available program limit for FDIC insurance. The bank list is subject to change.

See the IDM Disclosure Booklet for details, limitations, and eligibility requirements to participate in the IDM.

*The Annual Percentage Yield (APY) and interest rate shown is available in IDM and is part of the Asset Allocation Program (“AAP”). It is subject to a program fee of 0.25% (“Program Fee”) charged to DAIC as the program sponsor of AAP and is an asset-based advisory fee ranging from 0.00% to 2.00% (“Asset-Based Advisory Fee”). The actual interest rate received will vary and is based on the actual advisory fee charged. The APY and interest rate quoted, with a minimum balance of $0.01, is current as of the date shown. This rate is variable and may change daily without notice. Interest rates paid on deposits held at DTC are determined at the discretion of DTC. The APY is a rate based on monthly compounding of interest and assumes interest is not withdrawn from the deposit account and no changes to the interest rate for one year. The interest rate may change at any time at the discretion of DTC.

For the IDM, the program interest rate is impacted by several factors, including the total amount paid on deposits by the program banks, the fee paid to DTC and a fee paid to a third party that assists DTC in operating the program. DTC determines the portion of revenue it receives as a fee. The fee paid to DTC will affect the interest rate and may exceed the amounts paid to clients in the form of interest. Neither the program banks nor DTC is required to offer the highest rates available or rates comparable to money market mutual fund yields. In contrast, money market mutual funds generally seek to achieve the highest rate of return consistent with their investment objectives, which can be found in their prospectuses.

DTC, at its discretion, may determine that your account is ineligible to participate in the IDM. IDM provides up to $50 million of FDIC insurance.

The deposit rates and annual percentage yields are variable and may change at any time at DTC’s discretion. They are effective as of the date shown above. Interest will be accrued daily and credited monthly.

Unlike the IDM, non-deposit investments held by your broker-dealer (such as DAIC), are NOT FDIC INSURED / NOT BANK GUARANTEED / MAY LOSE VALUE.

©2024 Dunham & Associates Investment Counsel, Inc. All Rights Reserved

Dunham & Associates Investment Counsel, Inc. is a Registered Investment Adviser and Broker/Dealer. Member FINRA / SIPC.
Advisory services and securities offered through Dunham & Associates Investment Counsel, Inc. Trust services offered through Dunham Trust Company, an affiliated Nevada Trust Company.