Does deposit insurance do more harm than good?

You would have thought that after the Financial Crisis, it would have been a good time for policymakers rethink the efficacy of existing financial regulation — and not just slap another layer on top of the existing system.

Instead we got Dodd-Frank.

Example of a rethink that didn’t happen: deposit insurance. As AEI’s Alex Pollock wrote back in 2009:

In the last really big U.S. financial bust, that of the 1980s, the nature and role of deposit insurance in creating the problems was widely and prominently debated. After the public admission that, on top of hundreds of insolvent thrifts, the Federal Savings and Loan Insurance Corp. was itself insolvent, Congress declared that deposit insurance was explicitly a full faith and credit obligation of the United States. This it had never previously been.

By contrast, the role of deposit insurance in the 21st-century bubble and bust was hardly discussed at all, except to keep increasing FDIC coverage and guarantees. Discussion picked up recently, as it became apparent that the FDIC’s insurance fund was dramatically shrinking. Now that the FDIC has announced that it is insolvent–i.e., its net worth is negative–naturally it has become a hot topic. But it has not yet reached the point, as it did 20 years ago, of questioning the nature and wisdom of government deposit guarantees as a policy matter.

Plenty of reasons why deposit insurance is problematic, a big one being the moral hazard issue. And a new study by the KC Fed, of Kansas banks in the 1930s, illustrates the issue, as well:

This analysis of insured and uninsured banks in Kansas suggests that FDIC insurance was most appealing to weaker banks because it enabled them to compete for deposits on the same basis with stronger institutions.

Other studies (Wheelock and Kumbhakar 1995; Grossman 1992) have examined this same issue of adverse selection under deposit insurance and come to similar conclusions.

Moreover, these studies and an analysis of capital trends in Kansas banks indicate that deposit insurance can lead to moral hazard problems, which can provide an incentive for banks to take on more risk after they become insured and no longer face the discipline of depositors.

An important question is what implications the Kansas experience with uninsured banks might have for public policy and deposit insurance today. Deposit insurance is now a critical and seemingly permanent piece of the public safety net in the United States. Not only is deposit insurance important in protecting small depositors, but it is also key to maintaining financial stability and public confidence during periods of financial stress.

However, as shown by Kansas banks, deposit insurance removes a strong incentive that banks once had to maintain higher capital and exert tight control over risk exposures in order to attract and keep depositors. To the extent that these incentive issues under deposit insurance remain unresolved, the financial system may become more risky and more vulnerable to crises like the most recent one and the thrift.

Another example of the law on unintended consequences in action.


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