It sure seems like small banks won't be paying for March bank failures

Bloomberg News

This morning the Federal Deposit Insurance Corp. held a meeting to hear a semiannual report on the Deposit Insurance Fund, which under normal circumstances would not be considered fertile ground upon which to base a column that one might expect readers to actually read. 

But fortunately for me, the DIF has been rather a hot topic of late. With the failures of Silicon Valley Bank and Signature Bank just over a month ago, the FDIC took a roughly $20 billion loss to the fund — a loss that will be repaid by a special assessment on banks. And it also comes as the FDIC only just recently raised DIF fees to account for the glut of deposits that flowed into banks during the pandemic, which made the pie higher, as former President George W. Bush would have said, and thrust the DIF's balance below its statutory minimum. 

What is more, the tide seems to have been turning on those deposits, with hundreds of billions of dollars flowing out of the banking system and into money market funds over the last month — which is to say nothing of deposits flowing out of smaller banks and into larger banks. So the deposit level that the FDIC uses to calculate the DIF's statutory minimum — a level that is normally somewhat predictable — has become a more agile, moving target. 

But what I heard in the aggregate from members of the FDIC board of directors was something approaching a consensus that — at least as it pertains to replenishing the DIF via special assessment — small banks are the innocent parties that need protecting.

"I think it's clear there are a set of institutions who benefited [from the exception] more than others," said Consumer Financial Protection Bureau Director Rohit Chopra during the meeting. "I think we should make sure we fairly allocate those [costs]."

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It's a little early for vote counting, since FDIC chair Martin Gruenberg said the proposal for how the agency would replenish the DIF wouldn't be published until next month, and acting Comptroller of the Currency Michael Hsu and FDIC board member Jonathan McKernan didn't say anything during the meeting one way or another. But Chopra's expressed preference that banks who did not benefit from the systemic risk exception — read: small banks — be left alone is a decent indicator that the community banking sector is getting the treatment that it has been asking for. 

That actually makes sense, at least with respect to this pair of failures. Small banks by definition do not pose a risk to the financial system were they to fail, and so if a bank that does pose such a risk fails and takes some DIF money with it, it should be up to that failed bank's peers to bring the fund back to par. 

But there's a broader conversation happening right now about deposits, deposit insurance, systemic risk and contagion that makes me wonder how far that instinctual protection of small lending institutions ought to go. 

As long as I've been covering finance, there has been a kind of Hippocratic oath for bank regulators: First, do no harm to community banks. Again, this makes sense because those institutions are often the primary or sole lenders in their communities — community banks make something like 80% of agricultural loans and 36% of small-business loans nationwide. Those concentrations indicate that they're doing something that would not easily or efficiently be replaced by their larger peers, and if their individual failure won't hurt the financial system, the rules meant to protect the financial system from an individual bank's failure ought not to apply to them.

But as regulators start asking big questions about procyclicality and deposit insurance and what it means to be systemically risky, they should be wary of taking that hands-off approach to community banks too far. Just because one small bank can fail without consequence doesn't mean that many small banks making the same mistakes and meeting the same end wouldn't pose a systemic risk. Indeed, that was the case in the Savings and Loan crisis of the '80s and '90s, and that one was a doozy.

More to the point, Silicon Valley Bank and Signature Bank were also presumed not to be systemically risky — until it became apparent that the collateral damage to tech startups and multifamily housing was something that the economy couldn't do without. If enough small banks with a lot of agricultural loans start getting pinched by CRE losses, tighter net interest margin or deposit outflows, maybe all those little things add up to a big risk to the financial system. Stranger things have happened, and just in the last month.