deposit insurance Financial intermediaries, banks, and bank runs

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1 deposit insurance The purpose of deposit insurance is to ensure financial stability, as well as protect the interests of small investors. But with government guarantees in hand, bankers take excessive risks, driving up the chances of failure. Evidence suggests that these schemes increase rather than decrease the probability of financial crises. There is a good chance that deposit insurance does more harm than good. This article surveys the rationale for and history of deposit insurance, and discusses its consequences and possible alternatives. People living in countries where bank deposits are insured would never question the wisdom of an explicit insurance scheme. The idea that their savings are protected by a governmentbacked guarantee is something they simply take for granted. Only some crazy economist would ask whether deposit insurance makes sense. Well, does it? Surprisingly, the evidence is that it may not. Deposit insurance, which is supposed to stabilize the financial system, may do more harm than good. This article examines the nature of deposit insurance by answering the following series of questions: (a) What do financial intermediaries do that warrants government intervention? (b) What is the history of deposit insurance? (c) Does deposit insurance do what it is designed to do? And (d), are there any alternatives? Financial intermediaries, banks, and bank runs The term financial intermediaries encompasses a large set of institutions that include depository institutions as well as insurance companies, securities firms and pension funds. The first of these what we all call banks are both the most commonly known to individuals and provide the broadest array of services. They pool savings, accepting resources from a large number of small savers in order to provide large loans to borrowers; provide access to the payments system, so that individuals can make and receive payments; provide liquidity, allowing depositors to transform their financial assets into money quickly and easily at low cost; and diversify risk, giving even the smallest saver a mechanism for diversification. To appreciate the importance of financial intermediaries, consider what it would be like without them. If banks didn t exist, all finance would be direct, with borrowers obtaining funds 1

2 straight from the lenders. Such a system would be costly and ultimately ineffective. It would be so difficult and expensive for borrowers and lenders to find each other, and then to come to agreement over the terms of a loan, that it is unlikely there would be any transactions at all. And without a financial system to transfer funds from savers to investors, there would be no economic development. The world would be a very different place. Because of the services they provide, banks face a risk that other financial institutions (and industrial firms) do not. They are vulnerable to runs. Here s why. Banks issue liquid liabilities in the form of short-term demand deposits, and hold illiquid long-term assets, structured as securities and loans. The bank promises all its depositors that, if they want the entire balance of their checking account, they just have to come and ask. If a bank has insufficient funds to meet requests for withdrawal on demand, it will fail. Banks not only guarantee their depositors immediate cash on demand; they promise to satisfy depositors withdrawal requests on a first-come, first-served basis what is called a sequential service constraint. This commitment has important implications. Suppose depositors begin to lose confidence in a bank s ability to meet their withdrawal requests. True or not, reports that a bank has become insolvent can spread fear that it will run out of cash and close its doors. Mindful of the bank s first-come, first-served policy, panicked depositors rush to convert their account balances into cash before other customers arrive. Such a bank run can cause a bank to fail. Importantly, if people believe that a bank is in trouble, that belief alone can make it so. While banking system panics and financial crises can result from false rumours, they can also come about for more concrete reasons. Widespread downturns in economic activity drive down the value of loans and securities, so bank capital (the difference between assets and liabilities) falls. If things get bad enough, banks become insolvent and fail. A big economic downturn can put the entire financial system at risk. Gorton (1988) reports that significant contractions are associated with all seven of the severe financial panics in the United States that occurred between 1871 and In a market-based economy, the opportunity to succeed is also an opportunity to fail. It would be natural to dismiss bank failures as analogous to the closing of an unpopular restaurant. But, while individual banks should be allowed to fail, and are, the fact that banks are dependent on one another (in a way that restaurants are not) means that when one bank fails it puts others at risk. 2

3 Banks are linked both on their balance sheets and in their customers minds. In recent years in the United States, inter-bank loans make up roughly four per cent of bank assets an amount that represents almost half of bank capital. If one bank fails, it could put the system at risk. Information asymmetries are the reason that a depositor run on a single bank can turn into a bank panic that threatens the entire financial system. Most of us are not in a position to assess the quality of a bank s balance sheet. So, when rumours spread that a certain bank is in trouble, depositors everywhere begin to worry about their own banks financial condition. Concern about even one bank can create a panic that causes profitable banks to fail, leading to a complete collapse of a country s banking system. Bank failure is contagious. All of this leads to the following conclusions. Not only are individual banks fragile and vulnerable to runs, but the entire banking system is prone to panics. Contagion creates an externality that provides the economic justification for government intervention in the system. Deposit insurance and the government safety net Government officials intervene in the financial system both to protect small investors and to ensure financial stability. They do it with two related tools: the lender of last resort, where a central bank that can issue liabilities without limit provides loans to banks that are illiquid but not insolvent; and deposit insurance. History reveals that the presence of a lender of last resort significantly reduces, but does not eliminate, bank panics. The series of three bank panics in the United States during the Great Depression of the 1930s, described in Friedman and Schwartz (1963), is one example of a failure of this sort. The Federal Reserve System was in place and had the capacity to operate as a lender, but did not. The first national deposit insurance scheme was enacted by the US Congress in 1935 as a direct response to the bank panics in the 1930s. White (1995) sets out the history, noting that the debate was contentious, and that the stated purpose of deposit insurance was to stabilize the banking system. As surprising at it may seem from a modern perspective, investor protection per se was not the point. When one thinks about deposit insurance, it is important to keep in mind that no private fund can be large enough to withstand a system-wide panic. Only the fiscal authority (possibly combined with the central bank) has the necessary resources. 3

4 For decades the US system was nearly unique. In 1974 only 12 countries had explicit national deposit insurance systems. Explicit deposit insurance is a phenomenon of the last quarter of the 20th century, when it became a part of the generally accepted best-practice advice international organizations gave to developing countries. Demirgüç-Kunt and Kane (2002) report that by 1999 the number of countries with deposit insurance had risen to 71 (with the insurable limits ranging up to more than eight times a country s per capital GDP). Prior to this, most systems were implicit, whereby depositors would exert their substantial political influence to force fiscal authorities to supply unlimited deposit guarantees in the event of a bank failure. This is all somewhat surprising, given the obvious political appeal of any system that has no immediate budgetary outlay associated with it. What politician wouldn t want to make an apparently costless promise to protect the bank deposits of his or her constituents? Does deposit insurance work? In their classic theoretical treatment of deposit insurance, Diamond and Dybvig (1983) show that, if self-fulfilling depositor runs result from information asymmetries, then governmentsupplied insurance can improve social welfare. But at what cost? Insurance changes people s behaviour. Protected depositors have no incentive to monitor their bankers behaviour. Knowing this, a bank s managers take on more risk than they would otherwise, since they get the benefit of risky bets that pay off while the government assumes the costs of the ones that don t. In protecting depositors, then, the government creates moral hazard. This is not just a theory. In 1980, the deposit insurance limit in the United States was raised to $100,000, four times its earlier level. Over the following ten years, several thousand depository institutions (banks and savings and loans) failed. That was more than four times the number that failed in the first 46 years of explicit deposit insurance. While a vast majority of the institutions that failed in the 1980s were small, the cost of reimbursing depositors exceeded $180 billion. The bill was ultimately paid by US taxpayers. The problem of excessive risk taking did not stop with the resolution of the 1980s crisis. Today, the US banking system s assets are worth between 10 and 12 times their equity. In the 1920s, this same leverage ratio was closer to four. Industrial firms typically have leverage that is half that lower number. In other words, deposit insurance has driven up leverage in banking. 4

5 And with the increase in leverage comes an equal increase in risk (as measured by the standard deviation of returns). So, in an attempt to solve one problem, deposit insurance created another. And to combat bankers excessive risk taking, governments were forced to set up regulatory and supervisory structures. Among other things, there are now constraints on the assets banks can hold, rules governing the minimum levels of capital that banks must maintain, and requirements that banks make public information about their balance sheets. Supervisors have to enforce the detailed web of regulations. Does this complex mechanism actually work to stabilize the financial system? The evidence is not encouraging. Demirgüç-Kunt and Kane (2002) summarize international research and conclude that explicit deposit insurance actually makes financial crises more likely. When countries have either implemented a new scheme or expanded an existing one, the probability of crises has increased. To make matters worse, the creation of deposit insurance retards the evolution of non-bank financing mechanisms. Cecchetti and Krause (2005) find that countries with more extensive deposit insurance schemes tend to have both smaller financial markets and a fewer publicly traded firms per capita. To put it bluntly, deposit insurance is bad for financial development, and may be bad for real economic growth. Are there alternatives? So, if deposit insurance schemes do more harm than go, what should we do to stabilize the financial system? The natural response of an economist is to use the price system. Measure how risky a bank s balance sheet is, and set its deposit insurance premiums accordingly. Beginning in 1991, the US Federal Deposit Insurance Corporation did implement a risk-based premium structure. But this is extremely difficult to do well. Banks can always find ways to evade detailed rules, exploiting the system to reduce the prices they pay. In the end, this is not a solution. There are three other options. We could implement changes that further restrict the assets held by banks, eliminating their asset transformation function. We could increase our reliance on the central bank s lender-of-last-resort function. Or it may be possible to design a scheme to ensure that large depositors will impose discipline on the risk taking of bank managers. 5

6 Proposals for narrow banking are in the first category. A narrow bank is an institution that holds only a very limited set of very low-risk, highly liquid assets, such as short-term government securities. Since insolvency is impossible for such an institution, liability holders would not have to worry about the quality of the narrow bank s assets, and there would be no fear of a run. Deposit insurance would be unnecessary. Second, it may be possible to address the potential for systemic bank panics by improving the effectiveness of the lender of last resort. In 1873, Walter Bagehot suggested that, in order to prevent the failure of solvent but illiquid financial institutions, the central bank should lend freely on good collateral at a penalty rate. By lending freely, he meant providing liquidity on demand to any bank that asked. Good collateral would ensure that the borrowing bank was in fact solvent, and a high interest rate would penalize the bank for failing to manage its assets sufficiently cautiously. While such a system could work to stem financial contagion, it has a critical flaw. For it to work, central bank officials who approve the loan applications must be able to distinguish an illiquid from an insolvent institution. But during times of crisis computing the market value of a bank s asset is almost impossible, since there are no operating financial markets and no prices for financial instruments. Because a bank will go to the central bank for a direct loan only after having exhausted all opportunities to sell its assets and borrow from other banks without collateral, its illiquidity and its need to seek a loan from the government draw its solvency into question. Officials anxious to keep the crisis from deepening are likely to be generous in evaluating the bank s assets, and to grant a loan even if they suspect the bank might be insolvent. And, knowing this, bank managers will tend to take too many risks. Finally, we could require that banks issue subordinated debt. These are unsecured bonds, with the lender being paid only after all other bondholders are paid. Someone who buys a bank s subordinate debt has a very strong incentive to monitor the risk-taking behaviour of the bank. The price of these publicly traded bonds then provides the market s evaluation of the quality of the bank s balance sheet and serves to discipline its management. By eliminating the accountability of bank managers to their depositors, deposit insurance encourages risky behaviour. So, while financial stability is clearly in the public interest, deposit insurance may not be. Stephen G. Cecchetti 6

7 See also asymmetric information; Bagehot, Walter; financial intermediation; financial structure and economic development; moral hazard; risk Bibliography Bagehot, Walter Lombard Street: A Description of the Money Market. London: Henry S. Kin & Co. Cecchetti, S Money, Banking, and Financial Markets. Boston, MA: McGraw-Hill Irwin. Cecchetti, S. and Krause, S Deposit insurance and external finance. Economic Inquiry 43, Demirgüç-Kunt, A. and Kane, E Deposit insurance around the globe: where does it work? Journal of Economic Perspectives 16(2), Diamond, D. and Dybvig, P Bank runs, deposit insurance, and liquidity. Journal of Political Economy 91, Friedman, M. and Schwartz, A A Monetary History of the United States: Princeton, NJ: Princeton University Press. Gorton, G Banking panics and business cycles. Oxford Economic Papers 40, White, E Deposit insurance. Policy Research Working Paper No Washington, DC: World Bank. 7

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