Arnold Kling  

Deposit Insurance Revisionism

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This post is based on discussions with George Selgin and correspondence with William Melick. Melick sent a copy of a paper he wrote with Randall Kroszner, called "Lessons from the U.S. Experience with Deposit Insurance," in which they write,

the latest historical evidence accumulated from painstaking examinations of bank failures and panics suggests that contagion from unhealthy to healthy banks usually was not present during bank panics and failures. Rather, this evidence suggests that panics were usually associated with depositors moving from unhealthy banks (and banks associated with unhealthy banks) to healthy banks, what we term a separating equilibrium. Indiscriminate runs on all banks, what we term a pooling equilibrium, were relatively rare and in one instance triggered by official recourse to statewide bank holidays. This distinction between a separation and a pooling equilibrium provides a new prism through which to view the function of deposit insurance. If failures and panics are best viewed as separation equilibria, then using deposit insurance to protect the medium of exchange may preserve and encourage the expansion of unhealthy banks, potentially generating undesirable credit expansions that in the end prove quite costly.

This paper appeared as a chapter in this volume.

The standard view is that banking in a free market is inherently fragile, which makes deposit insurance necessary. In fact, some would argue that the concept of insurance needs to be extended to the so-called "shadow banking system." I think of Perry Mehrling and Gary Gorton as being in that camp.

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.

Instead, we created deposit insurance. That in turn led other countries to adopt deposit insurance, even though their banks were not as fragmented and risky as ours.

The net result of this spread of deposit insurance was to de-stabilize the banking system. That is because it created moral hazard, which regulators were not willing/able to offset.

I am not saying that I am on board with this revisionist analysis. But it is a provocative suggestion.

Comments and Sharing

COMMENTS (5 to date)
Philo writes:

Climb aboard!

Milton Recht writes:

You might want to look at this paper:

"To Establish a More Effective Supervision of Banking: How the Birth of the Fed Altered Bank Supervision" by Eugene N. White, Rutgers, The State University of New Jersey.

Although bank supervision under the National Banking System exercised a light hand and panics were frequent, depositor losses were minimal. Double liability induced shareholders to carefully monitor bank managers and voluntarily liquidate banks early if they appeared to be in trouble. Inducing more disclosure, marking assets to market, and ensuring prompt closure of insolvent national banks, the Comptroller of the Currency reinforced market discipline. The arrival of the Federal Reserve weakened this regime. Monetary policy decisions conflicted with the goal of financial stability and created moral hazard. The appearance of the Fed as an additional supervisor led to more competition in laxity among regulators and regulatory arbitrage by banks. When the Great Depression hit, policy-induced deflation and asset price volatility were misdiagnosed as failures of competition and market valuation. In response, the New Deal shifted to a regime of discretion-based supervision with forbearance.

Kyle writes:

Whether you think deposit insurance works or not might not be the primary reason one might want the “shadow banking” system to operate under the same rules (and assurances) as traditional banks. There could be value in having businesses that do the same thing (say, borrow short and lend long, such as traditional banks and SIV’s did) operate under the same regulatory structure, otherwise you have selection issues that may make the “shadow” portion more unhealthy than it would be if no one followed those rules.

Floccina writes:

With a free banking system with an option clause I do not see why there would be a need for deposit insurance or why there would be contagion. If a bank's notes fell below par I would guess that people would deposit the bank notes at other banks who would take he notes at a discount (same with deposits). Eventually the other banks would close the weak bank and take over its assets.

George Selgin writes:

For the record, although option clauses could in principle be useful in preventing panic-based bank runs, they never served the purpose in Scotland, and the Scottish system never needed them for that purpose. They were designed to thwart established banks' attempts to bankrupt upstart rivals by staging note raids on them.

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