Are Uninsured Bank Depositors in Danger?

One of Dan Colarusso’s favorite bloggers, Hugo Lindgren, picks up on the latest weekly newsletter

from Christopher Wood:

It is even more amazing that Obama does not understand the political appeal of the nationalization option. Maybe the so-called liberal Democrats are worried about adopting such a seemingly socialistic solution … but despite this latest setback nationalization of the banks is coming sooner or later because the realities of the situation will demand it. The result will be shareholders wiped out and bondholders forced to take debt-for-equity swaps, if not hopefully depositors.

"Seemingly" socialistic is right: even the AEI’s John Makin — no socialist he — is quoted in the NYT today as saying that “the lesson from Japan in the 1990s was that they should have stepped up and nationalized the banks.”

But what about those depositors? Paul Kedrosky is shaken by Wood’s conclusion:

I was with him right up until the last bit, but am I just sleep-deprived, or is Chris really arguing that there is a potential future where some U.S. bank depositors become forced equity holders?

It’s worth remembering that depositors are unsecured creditors of any bank; usually, indeed, they’re by far the largest class of unsecured creditors. Paul seems to think that they are, or should be, senior to bondholders: that might be true de facto, but it’s certainly not true de jure. *

It’s this very fact which led to the implementation of deposit insurance in most major banking systems; at this point we’re up to $250,000 in the US, which is a lot of money. If a bank fails, the FDIC will ensure that its depositors are paid out in full up to $250,000 each. But this is an insurance policy: it’s not a declaration that deposits are in any way senior to bonds. And if bondholders are forced to take a haircut, then by the principle of pari passu there’s a strong case to be made that depositors should take a haircut too.

In practice, this will apply only to uninsured depositors, of course. I’ve got a call in to the FDIC to find out what the total amount of uninsured deposits in the US banking system is, but given that total deposits as of June last year totaled over $7 trillion, it’s bound to be a large number.

(Update: Found it, at the top of page 17 of this pdf. Total domestic deposits at FDIC-insured institutions are $7.23 trillion, and total insured deposits are $4.54 trillion. Which means that total uninsured deposits are $2.68 trillion. That’s huge.)

The Washington Mutual precedent is interesting: the bank’s uninsured depositors remained whole even as its bondholders were largely wiped out. For the time being, I suspect that the FDIC will continue to try to make the distinction, and will put much more effort into protecting depositors than protecting bondholders. But as we’ve learned many times in recent history, it’s very dangerous to rely on precedent in such situations. And so there’s a good chance that at some point, a US bank failure is indeed going to result in losses for uninsured depositors. After all, that’s what always used to happen.

*Update 2: John Hempton calls to inform me that depositors actually are legally senior to unsecured bondholders, although they’re junior to secured bondholders.