JPMorgan’s acquisition of First Republic Bank after its spectacular collapse in April 2023 sparked immediate outrage among some financial policymakers. Democratic Senator Elizabeth Warren decried the transaction as  “troubling,” and Republican Senator JD Vance called it “a really bad deal for consumers [and] a really bad deal for the risk of our financial system.” In their and other critics’ view, merging First Republic with JPMorgan exacerbated the “too big to fail” problem, reduced competition, and bailed out wealthy tech companies that had imprudently kept billions of dollars of uninsured deposits at First Republic.

Despite these drawbacks, however, the Federal Deposit Insurance Corporation (FDIC) had little choice but to do the deal. That is because the FDIC’s governing statute requires the agency to resolve a failed bank in a way that incurs “the least possible cost” to the Deposit Insurance Fund (DIF). Based on the FDIC’s calculations, JPMorgan submitted the best bid of the four banks vying to acquire First Republic in the receivership auction. The FDIC also estimated that selling First Republic to JPMorgan would be cheaper than liquidating the failed bank and reimbursing First Republic’s insured depositors. Once the FDIC made these determinations, it was legally obligated to award First Republic to JPMorgan – regardless of the merger’s potential downsides.

Unquestionably, the Federal Deposit Insurance Act’s least-cost requirement was well-intentioned when Congress adopted it in 1991. At the time, regulators had just shuttered more than 1,000 depository institutions at a cost of more than $150 billion during the savings and loan (S&L) crisis. In the aftermath, lawmakers vociferously criticized regulators for using taxpayer funds to bail out insolvent institutions and protect uninsured depositors. By implementing the least-cost mandate, Congress sought to prevent the FDIC from depleting the DIF in the future when cheaper approaches were available.

In a new article, I contend that the ensuing three decades have demonstrated that the least-cost requirement is misguided and ought to be repealed. It is flawed in two ways: It overemphasizes costs to the DIF, and it undervalues the costs to society of resolving a failed bank.

First, the least-cost mandate places too much emphasis on the DIF. Many people mistakenly believe that the DIF is funded with taxpayer money. But in fact, it is funded by assessments levied on depository institutions, with progressively higher assessment rates on larger, complex firms. Thus, when the FDIC draws on the DIF to resolve a failed bank, it later replenishes the fund through assessments on banks, not through congressional appropriations of taxpayer funds. To be sure, banks may pass on a portion of deposit insurance assessments to customers, but some proportion of FDIC assessment fees are borne by bank shareholders and executives. Since the banking system internalizes at least some of the cost of resolving failed banks, minimizing costs to the DIF should not be the sole consideration for bank resolution.

Furthermore, DIF costs are nearly impossible to predict with precision. Calculating the liquidation value of a failed bank and valuing takeover bids involves numerous assumptions and estimations about the FDIC’s recovery rates on the failed bank’s assets, its liability under any loss sharing agreements, and potential profits on equity appreciation rights in the winning bidder. These projections are inherently uncertain and may produce widely variable forecasts. In one notable case, the FDIC’s cost estimate for resolving Silicon Valley Bank fluctuated by almost $6 billion as it sold the failed bank’s assets throughout 2023. This imprecision makes it challenging for the FDIC to accurately weigh competing resolution strategies and cautions against using this metric as the sole criterion for deciding how to resolve a failed bank.

In addition to overemphasizing costs to the DIF, the least-cost mandate  completely ignores other costs bank resolution may impose on society. These externalities come in many flavors. For example, an FDIC auction may lessen competition when a failed bank’s primary rival bids more for the failed bank than other suitors that do not compete directly. Similarly, an FDIC auction may increase future financial stability risks if a systemically important bank submits a better bid than other, less important banks, as was the case in the First Republic resolution. An FDIC auction could also perpetuate longstanding barriers in access to finance if a minority-owned depository institution is sold to a bank that does not prioritize financial inclusion. Yet under the least-cost mandate, the FDIC is prohibited from considering these potential downsides and must award a failed bank to the highest bidder, regardless of the consequences to society.

By examining the history and implementation of the least-cost requirement, my article exposes an underappreciated weakness in U.S. banking law. Since the 2008 financial crisis, policymakers and legal scholars have focused on improving resolution strategies for complex financial conglomerates through the Dodd-Frank Act’s Orderly Liquidation Authority, total loss absorbing capacity requirements, and “living wills.” By contrast, experts have largely ignored the FDIC’s traditional role in resolving failed banks, as distinct from diversified holding companies. The high-profile collapses of Silicon Valley Bank, Signature Bank, and First Republic Bank in 2023 revealed the need for renewed attention to the legal framework for depository institution resolution.

Left intact, the least-cost resolution mandate is likely to lead to a more concentrated, less competitive, and increasingly fragile and exclusionary financial system. Indeed, a failed bank’s direct competitors often have the strongest incentiveto acquire a failed bank in an FDIC auction, precisely because such a merger could enhance the acquirer’s market power. Moreover, mega-banks like JPMorgan have an inherent advantage when they bid in FDIC auctions because they benefit from a lower cost of funding than banks that are not perceived as “too big to fail.” In this way, future bank failures could produce a significant restructuring of the U.S. financial system, with long-term consequences for economic growth, distributional equity, and financial inclusion. In light of the high stakes, financial policymakers ought to be exceedingly thoughtful about the trade-offs involved in resolving failed banks beyond just direct costs to the DIF.

In my article, I recommend that Congress repeal the least-cost mandate and thereby allow bank regulators to consider all relevant societal costs when deciding how to resolve a failed bank. Alternatively, I suggest strategies for how the federal banking agencies can minimize harmful consequences while working within the constraints of the least-cost test if Congress declines to repeal it. Either way, reforming the prevailing approach is essential to ensure that failed-bank resolution policy promotes competition, financial stability, and financial inclusion instead of detracting from these important objectives.

This post comes to us from Jeremy C. Kress, associate professor of business law at the University of Michigan’s Stephen M. Ross School of Business. It is based on his recent article, “‘Least-Cost’ Resolution,” available here.