Depositor liquidity and loss-sharing in bank failure resolutions

Bank failures are widely feared for a number of reasons, including concern that depositors may suffer both losses in the value of their deposits (credit losses) and, possibly more importantly, restrictions in access to their deposits (liquidity losses). In the United States, this is not true for insured deposits, which are fully protected and made available to the depositor almost immediately. But both problems may occur for uninsured depositors. Thus, there is pressure on regulators to protect all depositors in bank failures. This is likely to increase both moral hazard risk-taking by banks and poor agency behavior by regulators with large ultimate costs to taxpayers. While ways of reducing the credit loss in bank failures have been widely examined, reducing liquidity losses has received far less attention. One way to mitigate this loss to uninsured depositors is to make the estimated recovery value of their deposits quickly available to them upon failure of the bank through an advance dividend or other payment by the FDIC secured by the bank's assets. Quick depositor access was suggested as a superior solution to deposit insurance in alleviating adverse effects from bank failures during the debate on deposit insurance in the early 1900s and was actually put into effect by both the Reconstruction Finance Corporation and the New York State Banking Department shortly before the establishment of the FDIC. More recently, the FDIC has experimented with the concept. This paper analyzes the pros and cons of providing quick depositor access to deposits at failed banks and reviews the history of the concept. It concludes that such a policy would greatly enhance the FDIC's ability to resolve large bank insolvencies without having to protect uninsured depositors through too-big-to-fail policies.