Implementing unlimited deposit insurance would only lessen the market discipline of banks and enable politically motivated regulatory overreach.
Implementing unlimited deposit insurance would only lessen the market discipline of banks and enable politically motivated regulatory overreach.
T he Nobel Prize-winning economist Paul Krugman has written that zombie-economic ideas are a great impediment to good policy making. Over the past few months, the idea of expanding government deposit insurance has resurfaced; it’s a bad idea that just refuses to die.
Following the collapse of Silicon Valley Bank and Signature Bank in March, the Federal Deposit Insurance Corporation (FDIC) released a paper outlining various ways to reform the current system of deposit insurance. Most of its suggestions amounted to expanding the level of deposit insurance. This is a mistake that Congress should avoid. It would encourage risky bank lending and politically motivated regulation.
The FDIC paper detailed three pathways for reform: maintaining the present level of deposit insurance, creating a system of unlimited deposit insurance, or providing targeted deposit-insurance increases across different types of accounts. The paper gained little traction in Congress but came under a withering barrage of criticism from economists and financial experts.
In spite of this criticism, however, on August 23rd Representatives Dan Meuser (R., Pa.) and Blaine Luetkemeyer (R., Mo.) of the House Financial Services Committee sent a letter to the FDIC requesting further information on the various recommendations made therein. The policies specified in the letter varied, but all would expand the level of deposit insurance.
As noted by a number of authors, myself included, government deposit insurance weakens the incentives for depositors and shareholders to monitor and discipline the risk-taking of banks. Under such conditions, banks can capture the gains from making risky loans, while only bearing a portion of the costs. With banks having fewer incentives to act responsibly, their portfolios become increasingly risky, setting the stage for financial crises. This has been the effect of government deposit insurance throughout its history.
What would a system of unlimited deposit insurance look like? Mexican economic history provides a recent example. From 1991 to 1996, the Savings Protection Banking Fund (Mexico’s version of the FDIC) committed itself to protecting all bank liabilities. The results were predictable: Depositors and shareholders failed to properly monitor banks, leading to greater risk taking. Between 1991 and 1994, total private lending increased from 1 million pesos to just over 2 million pesos, outstripping the growth in the deposit base by 20 percent over roughly the same period. That is, bank loans outpaced banks’ ability to fund them via attracting deposits, with the difference being made up primarily by loans from other (mostly foreign) banks.
This expansion in bank credit contributed significantly to Mexico’s financial distress in the wake of the mid-’90s peso crisis, requiring a massive government bailout for insolvent financial institutions. These bailouts cost Mexican taxpayers approximately 692 billion pesos, roughly 15 percent of the nation’s gross national product.
Mexico’s experiment with unlimited deposit insurance indicates that such schemes are fundamentally unsound. Risky behavior would manifest regardless of whether increases in the insurance level were enacted wholesale (by increasing the maximum insurable deposit amount) or selectively.
Programs enabling the FDIC to selectively provide excess deposit insurance would give the FDIC the discretion to make coverage contingent on banks’ meeting certain lending criteria. Indeed, the representatives’ letter suggests that to qualify for additional coverage, pre-certification could be required, meaning account holders would have to specify what the cash in their accounts would be used for. In addition to increasing compliance costs, such programs would further politicize the financial system.
Politics is often transactional, and would be made all the more so by excessive deposit insurance. Guarantees by the FDIC could be made contingent upon certification by either banks or account holders that funds not be used in connection with controversial industries such as oil and gas exploration, marijuana production, or gun-store establishments. As the revelations around Operation Choke Point have illustrated, the FDIC has previously used its regulatory powers to target politically disfavored industries under the guise that they posed “reputational risks” to financial institutions.
Implementing unlimited deposit insurance — or selectively expanding deposit guarantees for certain account types — will only lessen market discipline of banks and enable politically motivated regulatory overreach. None of this improves the efficiency or stability of the American financial system.
A better idea would be to reduce the current level of deposit insurance and allow private deposit-insurance providers to compete for savers’ funds. Such a reform would embrace market mechanisms without inserting political considerations into the financial system. As for junk ideas about expanded or unlimited deposit insurance, Congress should forget them.