Smaller US banks have big problems. For now, their focus is on survival. That is why the Mid-Size Bank Coalition of America has pleaded for an extension of deposit insurance to staunch the outflows. But even after stability is restored, the lending capacity of regional banks will be severely constrained. That will damage the US economy.

The request to widen federal deposit insurance to deposits over $250,000 for the next two years shows that distrust of US banks has a momentum of its own. The MBCA argues that the move would immediately halt the exodus of deposits.

It should not have come to this. Opponents of risk-free deposits rightly fret about moral hazard.

Temporary guarantees might be needed even so. Former FDIC chair Sheila Bair says the flight of deposits could make the biggest banks even bigger, while otherwise healthy lenders get into trouble.

Regulators and politicians will do their utmost to avert that threat. As well as potentially extending deposit insurance, they are providing access to ample liquidity. Yet even if they succeed in calming the immediate crisis, smaller US banks will bear the scars.

The issue is not just that the regional banks’ advantages over larger rivals — more lenient regulations and lower capital requirements — are likely to be reconsidered. It is also that some of the deposits that have relocated in the current panic will not return.

If regional banks are left with a smaller “sticky” deposit base, they could, in principle, get liquidity from the Fed’s Bank Portfolio Funding Program. However, its relatively high cost — the one-year Overnight Indexed Swap plus 10 basis points — makes it an unattractive source of new loans, Jefferies analysts say.

That points to a credit crisis that will hit Main Street, not Wall Street. The regional banks helped drive the small business boom. Their willingness to lend was already fading even before the latest bank runs. Extending the guarantee on deposits would shore them up. That will not avert the coming lending crunch, but it would make it less severe.

The Lex team is interested in hearing more from readers. Please tell us what you think of extending deposit guarantees in the comments section below.

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