More deposit insurance would promote financial instability.
More deposit insurance would promote financial instability.
I n his weekly Newsweek column, the economist Henry Hazlitt once observed that “the government is not a canny lender.” As the recent collapse of Silicon Valley Bank (SVB) so painfully illustrates, the government isn’t much better as an insurer, either. Unfortunately, officials have not learned this lesson.
In light of SVB, the Federal Deposit Insurance Corporation (FDIC) released a set of recommendations for reforming deposit insurance that included a proposal to enact unlimited deposit guarantees, among others. That is, the FDIC has recommended that the ceiling on its deposit insurance be extended not just to “small deposits” (of $250,000 or less) but to so-called “excess deposits” as well (deposits greater than $250,000). It’s worth noting that of the 860 million deposit accounts reported by financial institutions, only 0.83 percent are greater than $250,000, with about half of these being held at the 13 largest banks in the United States.
Implementing unlimited deposit-insurance guarantees would not only worsen the issues with financial stability that plague the financial system but would protect individuals and institutions who already possess the wherewithal and sophistication to ensure the security of their own savings without the benefit of a government guarantee.
The FDIC’s recommendations indicate that policy-makers have not learned the lesson presented by the collapse of SVB and Signature Bank. Rather than preventing banking crises by securing depositors, government deposit insurance actually increases the likelihood that such crises will occur. The banking system obviously has its flaws, but the existence of the FDIC’s guarantee risks increasing the chances that those flaws will go undetected until too late.
Created in 1933 during the height of the Great Depression, the FDIC was formed with the express purpose of minimizing losses to depositors in the event of a bank failure by guaranteeing the repayment of all deposits up to a certain amount. On its face, such a system would seem to improve the stability of a banking system and the security of depositor’s savings. However, there is plenty of evidence that the opposite is true.
By providing guarantees for depositors’ savings, the FDIC inadvertently introduces “moral hazard” into the banking system. That is, FDIC guarantees actually promote risk-taking by ensuring that risk-takers do not bear the full costs of making risky loans or maintaining too-low capital ratios.
This occurs in two ways: one, by increasing the risk appetite of lenders; and two, by lowering the incentive of depositors and shareholders to curtail the risk-taking behavior of bank managers either by demanding that the bank maintain a larger capital cushion or higher interest rates on their deposits. The result is the building up of risk in the financial system, which contributes to periodic panics and crises.
The tendency of government deposit insurance to increase rather than decrease the fragility of banks and the financial system as a whole has been well documented by economic historians. Before the establishment of the FDIC, 14 states experimented with deposit-insurance schemes between 1829 and 1930. These early funds, whose design mirrored that which would eventually define the FDIC, were plagued by issues of moral hazard and the promotion of risk-taking among insured banks. These issues compounded until bank failures rendered the funds insolvent, requiring taxpayers to cover the (often sizeable) deficits left over by these funds.
The insurance schemes established in New York, Ohio, and Iowa, however, managed to avoid these problems by embracing a system of mutual monitoring and restraint. That is, every insured bank was held liable for the losses incurred by other member banks, thereby incentivizing the monitoring and sanctioning of excessive risk-taking. The mutuality of these systems allowed them to survive until they were ended via legislation during the Civil War. The FDIC’s insurance scheme was designed to mimic the mutuality of these successful state-level schemes. However, the FDIC’s guarantees are underwritten by taxpayers, again, reducing the incentive to engage in monitoring and allowing banks to pass off the costs of their risk-taking onto the broader tax base. Thus, the lack of self-regulation in the present-day system of deposit insurance helps to explain why it is so crisis-prone.
More recently, several studies have shown that federal guarantees of deposits contributed to both the savings-and-loan crisis of the 1980s (in the case of S&Ls via guarantees provided by the Federal Savings and Loan Insurance Corporation) and to the 2008 financial crisis. The collapse of SVB is just the most recent in a long line of bank failures that can be partially attributed to the pathologies of federal deposit insurance.
Policy-makers are correct in identifying a need to reform the regulatory framework that undergirds the American banking system; however, they are incorrect in advocating increased deposit insurance. Indeed, a growing chorus of economists and policy-makers are criticizing this proposal.
In its present state, the FDIC’s deposit guarantee preserves a degree of self-regulation through the existence of uninsured depositors. Institutions and individuals whose deposits are greater than $250,000 retain the incentive to monitor bank risk-taking and remove their deposits from banks that have taken on too much risk. Lifting the ceiling on the maximum amount of insurance would eliminate this last source of market discipline on banks. While it could be argued that raising the insurance limit would help prevent “unnecessary bank runs,” it is an open question as to whether such withdrawals actually exist. Indeed, studies of various 20th-century bank runs have shown that, rather than representing irrational panics on the part of depositors, they have instead consisted of the movement of deposits from unhealthy to healthy institutions.
Instead, reforms should be aimed at increasing the degree of self-regulation, rather than government regulation, in the banking system — that is, strengthening the incentives faced either by other insured banks or by stockholders and depositors to monitor and restrain risk-taking on the part of bank managers. Such self-regulation has been shown to produce stability in the past, and it can do so again.