Frontiers of Growth
An Alternative to Deposit Insurance
Antoine Martin
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Argentina's financial panic and the run on its banks that ensued, as well as Asia's financial crisis of 1997, have forced a number of countries to consider adopting deposit insurance schemes to protect their citizens' savings. But is deposit insurance the best defense against bank panics?
Deposit insurance was a response to banking crises of the type that plagued the United States until the 1930's. The first explicit scheme was introduced in America after the Great Depression and initially seemed an unmitigated success. Panics no longer occurred, which stabilized the financial system and contributed to sustained post-war economic growth.
Deposit insurance did away with financial panics because bank runs are typically driven by a self-fulfilling prophecy. They occur when a bank's clients fear that most of their fellow depositors will withdraw their funds. Because banks service their depositors on a first-come-first-served basis, those who wait risk being left empty-handed, because the bank may be forced to liquidate its long term-assets at a loss and run out of resources. So fear of a panic can create a panic. This is highly inefficient, because while it is individually rational for depositors to want their money immediately, the bank might have been able to service all of them had they been collectively patient.
Economists call such situations "coordination failures," if depositors could talk to each other and coordinate their actions, they would be able to avoid a self-defeating run on the bank. By guaranteeing that there will be enough resources available for patient clients when they want to withdraw their funds, deposit insurance eliminates the coordination failure. Patient depositors no longer need to worry about others withdrawing their funds because it has no effect on them.
But deposit insurance leads to other problems, which first appeared with the Savings and Loan crisis in the US during the 1980's. Deposit insurance creates what economists call "moral hazard," people who are insured against an unpleasant event are not as careful as they would otherwise be in trying to avoid that event. If my bicycle is insured against theft, I might buy a cheaper lock for it, making it more likely that it will be stolen. With deposit insurance, clients who no longer risk losing their money have no incentive to monitor their bank, while banks, with no one watching, have incentives to invest in excessively risky projects.
Although many factors contributed to the Savings and Loan crisis, it is generally agreed that moral hazard was a major one. Following that crisis, deposit insurance in the US was reformed with the objective of mitigating the moral hazard problem. But did the reforms go far enough? There are ways to improve the existing system, but is something altogether different and better possible?
As far back as 1873, in his classic book on central banking, Lombard Street , Walter Bagehot noted that central banks should be able to prevent financial panics by injecting liquidity into the economy. I have studied policies of the type proposed by Bagehot in a way that allows me to compare them with deposit insurance schemes. The main conclusion of my work is that policies aimed at ensuring liquidity can not only prevent bank panics, but also avoid the excess risk-taking that deposit insurance encourages.
In case of panic, a good policy should help banks that have enough assets to cover their deposits but that can't pay all depositors at the same time because some assets are tied up in real estate or other long-term investments. These banks are illiquid but not insolvent . The central bank can help with familiar tools. Under a repurchase agreement, for example, monetary authorities buy assets from an illiquid bank under the promise that the bank will then buy the assets back on a specified date and for a specified price. In this way, the bank temporarily exchanges its illiquid assets for cash, pays off its depositors, and avoids doing so at a loss.
As with deposit insurance, repurchase agreements solve the coordination failure problem because depositors know that, even if they wait, the bank will be able to accommodate their withdrawals. In contrast to deposit insurance, however, liquidity provision can avoid moral hazard by helping only those banks that are solvent. Depositors still have a strong incentive to monitor their banks.
Consider a bank that has invested in risky projects and finds itself in trouble. It can ask the central bank for help and sell some of its assets for cash. However, under the agreement with the central bank, it must buy its assets back. If the assets are worthless, it will ultimately be forced out of business. If it declares bankruptcy and refuses to buy back its assets, bankruptcy laws should give the central bank the first claim on the bank's assets. This creates a powerful incentive for depositors and investors to monitor their bank's performance.
Implementing liquidity provision policies like those advocated by Bagehot would prevent bank panics without the incentive for undue risk-taking associated with deposit insurance. Depositors deserve strong, effective protection for their funds--and the banking system requires it in order to maintain confidence. But neither depositors nor their banks should be given a free ride.
Antoine Martin is an economist with the Federal Reserve Bank of Kansas City.
Copyright: Project Syndicate, July 2002
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