The Rumor at Riverbend Savings
Riverbend Savings is a $1.2 billion community bank. Loans are 84% of assets; uninsured deposits are 22% of deposits; available-for-sale securities of $150 million carry $14 million of unrealized losses. Its liquidity coverage ratio is 108%, just above the 100% minimum. A local employer announces layoffs, and a social-media rumor says Riverbend is insolvent. In two days, depositors withdraw $95 million. To meet withdrawals, the bank can sell AFS securities at a loss, borrow $60 million from the Federal Home Loan Bank at 4.8%, borrow at the discount window at 5.0% (primary credit), or raise equity. The CEO wants to sell securities immediately to avoid stigma. The board asks for a funding plan and an assessment of deposit insurance.
1. Rank the funding options and explain the trade-offs, including fire-sale losses and stigma.
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Rank by preserving the bank's franchise and minimizing forced loss recognition:
- Use cash and maturing assets.
- Borrow secured from the FHLB against loans and securities. This does not crystallize the AFS loss and keeps the asset base intact, but it adds encumbrance and may raise funding cost.
- Use the discount window. Primary credit is a legitimate liquidity backstop, but stigma can signal weakness. The CEO's fear is rational, yet it should not drive the sequencing; regulators can encourage use.
- Sell AFS securities only after cheaper secured funding is exhausted, because a sale at a 9.3% loss converts a temporary liquidity problem into a permanent capital loss.
- Raise equity only if the run reveals solvency concerns; in a run, equity investors demand a steep discount.
The optimal plan is a prearranged FHLB line plus discount-window backup, with clear communication to large depositors. Selling securities first is the most expensive option per dollar of liquidity and can accelerate the run by signaling desperation.
2. Calculate the immediate capital impact of selling $95 million of AFS securities if the unrealized loss is 9.3% of the securities sold. If CET1 is 9.8% of risk-weighted assets and RWAs are $900 million, does the bank remain adequately capitalized?
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Unrealized loss rate = 14/150 = 9.33%. Selling 95 million realizes 95 × 0.0933 = 8.87 million of loss.
CET1 capital before sale = 9.8% × 900 = 88.2 million. After the loss, CET1 = 79.33 million. If RWA remain at 900 million, the CET1 ratio is 8.81%. If RWA fall because the cash is used to pay deposits, the ratio is slightly higher, but the capital buffer is thinner.
The bank remains above the 4.5% minimum and the 7% buffer, but not comfortably. A further outflow that forces a 300 million sale would realize about 28 million of loss and push CET1 toward 6.7%. Capital is adequate for a small shock, not for a continuing run. That is why the funding sequence matters: preserving capital is as important as meeting the next withdrawal.
3. How does deposit insurance change depositor incentives and bank risk-taking? Is this run mainly a liquidity shock or a moral-hazard problem?
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Deposit insurance weakens the incentive of insured depositors to monitor and to run, which stabilizes the liability side. But it also reduces market discipline: insured depositors accept lower yields and do not price bank risk, so the bank can take more risk. The 22% uninsured deposits remain sensitive to news, so the run can start with them.
This run is primarily a liquidity shock triggered by an information asymmetry about asset quality, not necessarily by insolvency. Insurance does not protect the uninsured fifth of deposits, so they run first. The policy response should be liquidity support plus credible disclosure. Raising insurance coverage would reduce run risk but increase moral hazard unless paired with supervision, capital requirements, and resolution rules. The bank should not be bailed out for solvency losses; liquidity support should be secured and priced.