Economics, Pethokoukis

One way to reform deposit insurance

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The financial crisis failed to lead to a comprehensive rethink of our approach to financial regulation. We just slapped on another layer of regulation called Dodd-Frank. Take deposit insurance, which may well be yet another example of government regulation and guarantees producing unintended consequences. Indeed, this appears to be the case from the deposit insurance program’s very beginning. A recent Kansas City Fed study of Kansas banks in the 1930s came to this conclusion:

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.

Arnold Kling calls deposit insurance a government-created solution to a government-created problem:

The revisionist view is that deposit insurance is a case of the government concocting a solution to a problem that was created by government in the first place. That is, the U.S. banking system was unstable due to regulations that promoted small, local banks and inhibited the creation of diversified nationwide banks. Had banks been allowed to branch across state lines or had national bank holding companies been allowed to grow naturally, then (according to this argument) we would have seen few bank failures, even in the 1930′s. Hence, there would be no need for deposit insurance.

Is there a way to reduce the moral hazard problem that deposit insurance creates without eliminating this long-standing and popular feature of the US financial landscape? AEI’s Alex Pollock has a suggestion for how to deal with depositors when it comes to sharing the losses of failing banks:

How about preserving the classic idea of small savings and thus savings accounts, conjuring up as they do visions of Jimmy Stewart and the virtues of thrift? OK, let’s exempt these from sharing in losses, too. Savings deposits represent another 17% of U.S. deposits. Between transactions accounts and savings accounts, we have 30% of deposits.

Now: what about the other 70%: the nontransactions, nonsavings deposits? What are they? They are simply fixed-income investments made for a yield, in competition with lots of other notes and bonds. These deposits include time deposits, certificates of deposit, money market deposit accounts and notably, brokered CDs. As fixed-income investments, they are an excellent candidate to join other fixed-income investments, i.e., bonds, issued by banks, as creditors to be bailed in, consistent with Katainen’s ideas.

Because they are simply fixed-income investments with a different name, in a reformed world, 70% of deposits might rank pari passu with senior bonds when it comes to sharing losses. Obviously, this makes them junior to transactions accounts and savings accounts, and also junior (instead of senior, as they now are) to taxpayers.

Such a bail-in would substantially reduce the perverse incentives and moral hazard of government deposit insurance, while arguably being more true to its original purpose. Buyers of these investments would care a lot more about the credit standing and capital of the bank and need appropriate disclosures, just like buyers of other investments sold to the public. Deposit insurance would have to be restructured. Banking leverage would fall and capital ratios would rise. People would work on how to game the system, of course, but moral hazard in banking would be much reduced.

2 thoughts on “One way to reform deposit insurance

  1. Of course, when the shadow banking industry cratered in the housing bust and money funds threatened to break the buck, the Treasury stepped in with a promise of liquidity. The Treasury would have had to do the same to stem runs at banks if the FDIC went away When the problem is asset related, banks fail in droves, as in OK, TX, AZ, MA. 9 of 10 bank holding companies in Tx failed in the ’80s, but without significant runs. Hard to imagine TX operating on a cash basis, eh?

    BTW, Dodd Frank is a first layer of regulation on mortgage lending and borrowers’ rights. The Fifth National was heavily regulated for safety and soundness but if it decided to it didn’t like your interest rate lock any more, tough cookies.i

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