Two main problems with deposit insurance

“Bank runs are a common feature of the extreme crises that have played a prominent role in monetary history. During a bank run, depositors rush to withdraw their deposits because they expect the bank to fail. In fact, the sudden withdrawals can force the bank to liquidate many of its assets at a loss and to fail. During a panic with many bank failures, there is a disruption of the monetary system and a reduction in production.”

(Diamond & Dybvig, 1983) 

Government guarantees & ‘too big to fail’

When a company becomes insolvent, creditors to that company will usually lose a proportion of their money. In the case of a bank, this would involve depositors only receiving a percentage of the full value of their account. However, in the UK (and in most other countries) the government guarantees that if a bank fails, the customers of that bank will be able to claim a certain percentage or a capped amount of their deposit back from the government. This guarantee on the money in a bank account is known as ‘deposit insurance’. In a country with deposit insurance, in the event of insolvency the insolvent bank will have its assets sold off. Any funds raised in this way are used to reimbursed depositors, with any shortfall being made up with funds from taxpayers.

The first system of deposit insurance was established in America in response to the Great Depression. Its purpose was to prevent the bank runs that contributed to the depression from ever happening again. Deposit insurance is based on the idea that if depositors know that the government will reimburse their deposits in the result of a bank failure, then they will not bother attempting to withdraw their deposits even if they find out the bank is insolvent. This is intended to prevent runs on banks that are rumoured to be insolvent or experiencing financial difficulty. In addition those banks that are insolvent will not have to undertake a fire sale of their assets in order to quickly raise money. Fire sales are undesirable because they can lead to a crash in asset prices, which can also lead to the insolvency of others (including banks) that hold similar assets. Left unchecked, a debt deflation may result.

In the UK today the government provides deposit insurance (via the Financial Services Compensation Scheme, FSCS) to most bank accounts up to a limit of £85,000. In theory the FSCS is funded by levies on banks whose customers are covered by the guarantee, but in practice the major contributors to the cost of the scheme have been taxpayers. Due to the failure of certain banks in 2008-09, just £171 million of the £19.86 billion (less than 1%) was funded through levies, while the rest was provided by government (Financial Services Compensation Scheme, 2009).

There are two main problems with deposit insurance. The first is that by being insured, customers will take little or no interest in the way that the bank lends and takes risks. This is known as ‘moral hazard’. (1) 

In a system without deposit insurance, depositors would have a strong incentive to monitor their bank’s behaviour to ensure the bank does not act in a manner that may endanger its own solvency. For example, a depositor would be concerned with the types of loans their bank was making and the amount of capital their bank had (capital acts as a buffer, protecting depositors from losses when loans go bad). Other things being equal a bank with a higher capital ratio would be considered safer and in consequence could be expected to attract more customers than a bank with a smaller capital base. However, in a system with deposit insurance there is no incentive for customers to monitor their bank’s behaviour, as depositors are guaranteed to receive their money back regardless of the level of risk taken by the bank. This lack of scrutiny from customers (or the financial press) means that banks are not restricted to taking the level of risk that their depositors would be comfortable with. Instead, they are free to lend as much as they like to whomever they like, in the process lowering their capital ratio (increasing their leverage) (2). Thus the presence of deposit insurance removes one potential constraint on the banks’ desire to lend and increases the riskiness of their lending.

The second problem with deposit insurance regards the insolvency procedure and its costs in the case of a bank failure. In a country with a deposit guarantee scheme, bank insolvency normally means either a government bailout of the bank in question, or the closing of the bank, the sale of its assets and compensation for deposit holders up to the designated amount. How likely are governments to take the second option? The case of RBS (Royal Bank of Scotland) is useful here.

When RBS ran into trouble during the financial crisis, the government had the option to close the bank and let it fail (as would happen to any non-bank business that became insolvent). However, because of its obligation to reimburse the depositors of RBS, the government would have been obliged to find approximately £800bn – greater than the entire national debt at that time, and similar in size to the UK government’s annual tax take. Of course, in an ideal world much of this could potentially have been raised by the sale of RBS’s remaining (good) assets. However, the government was constrained in its actions – it had to resolve RBS quickly. Any delay could cause the panic to spread to other banks, amplifying the original problem. Finding buyers for £800 billion of assets is hard at the best of times, especially when those assets are from a failed bank. In the middle of a financial crisis it is close to impossible. As a result the government would have most likely had to accept a price for the assets far below their market value, and would need to make up the shortfall from taxpayer’s funds or borrowing. In addition, the majority of RBS’s assets were loans. These are difficult to value quickly (due diligence takes time), and in consequence the government would once again have had to accept a price below market value. Invoking bankruptcy procedures against RBS would have therefore been highly costly to the government.

A further problem with allowing a large bank to fail is that it could lead to problems at other banks. First, because banks owe each other large amounts of money a failure could lead to insolvencies at other banks due to the non-repayment of loans. This can lead to a cascade of bankruptcies throughout the entire system. Second, insolvency at one bank can lead to runs on solvent banks as depositors panic about their own bank’s position. The belief a bank is insolvent can become a self fulfilling prophecy, as a fire sale of assets reduces their value. Third, the payment system itself may be affected by bank insolvency: many banks do not have direct access to the high value payment systems, instead accessing them indirectly through a correspondent bank (known as a settlement bank). If the settlement bank became insolvent this could create problems in the payment system, as the ‘customer bank’ would not be able to make or receive payments. In addition, insolvency at either the customer or the settlement bank could lead to insolvency at the other bank.

For example, if a settlement bank makes payments with their own liquidity on behalf of their customer banks, they are in effect lending to their customer bank until the accounts are settled at the end of the day. Likewise, if a settlement bank receives more payments to their customer bank than the customer bank makes during the day then in effect the customer bank is lending to the settlement bank (again until the accounts are settled at the end of the day). Depending on who owes who, bankruptcy (and therefore default on borrowings) of either bank during the day may create problems for the other bank. These are not simply theoretical risks: “During the great depression 247 US banks were closed between January 1929 and March 1933 due to the failure of a correspondent [bank]”. (Salmon, 2011) Similar issues almost materialised in the 2007/08 financial crisis:

“In one of the UK payment systems, a UK bank that got into difficulty made its payments through a much smaller bank, in terms of balance sheet size. These exposures could well have put the smaller bank in significant financial difficulty had the authorities not intervened in the failing bank.”

These risks may also spill over into the rest of the payment system if banks start delaying their payments due to uncertainty as to the status of one or more banks.

Fourth, the failure of a bank may negatively affect the flow of credit (i.e. lending) to the economy, particularly if the bank services a large proportion of the lending market. For example, RBS accounts for a significant proportion of all lending to UK businesses, meaning that its failure would have been devastating for small and medium sized businesses (which employ around half of all workers in the UK).

For all of these reasons, banks can be deemed ‘too big’, or ‘too systematically important’ to fail. (3) As a result of these costs and potential risks, a cheaper and safer option for the government was to effectively give RBS £45.5 billion in exchange for newly issued shares. This became an asset of RBS, making its net worth positive again.

Large banks fully understand that deposit insurance means that if they become insolvent, the choice facing government is between repaying all their customers due to deposit insurance, or rescuing the bank through an ‘injection of capital’ (a bailout). In practice, it will always be many times cheaper and safer to rescue a bank that to let it fail. This knowledge will lead the bank to take higher risks, knowing full well that the government will be unable to afford not to rescue it if it should fail. The larger the bank, the greater the cost to government of allowing it to fail, and the more confident the bank will be that it has a guaranteed safety net even if the risks it takes backfire and it becomes insolvent. Banks will therefore lend greater amounts and lend to riskier borrowers than they otherwise would do, which will in turn lead to a larger money supply.

In the Positive Money system, a system without deposit insurance, depositors and bank creditors would have a big incentive to monitor their bank’s behaviour, to ensure it does not act in a manner which may endanger its solvency.

While Investment Account holders may benefit from the upside of an investment (by receiving interest on their deposits/lending), they would also suffer the downside if things would go wrong (i.e. they may not receive the full value of their deposit back).

Risk and reward would be aligned, and the subsidy to banks would be removed.

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1. Moral hazard is when the provision of insurance changes the behaviour of those who receive the insurance, usually in an undesirable way. For example, if you have contents insurance on your house you may be less careful about securing it against burglary than you might otherwise be. 

2. Furthermore, instead of caring about their bank’s solvency, depositors are incentivised by the interest rate on different bank accounts. In order to attract funds, banks will have to offer higher rates of interest on their accounts than their competitors. Thus, in order to maintain their profit margins they will have to charge borrowers higher rates of interest. Other things being equal those willing to borrow at higher interest rates will be those taking the greatest risks, which increases the risk of default.

3. The idea of something being too big to fail runs contrary to the very principle of capitalism – under a capitalist system a business that does badly is meant to fail.

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This is an extract from the book Modernising Money that explains why the monetary system is broken, and how it can be fixed.

Here you can read the Positive Money system explained in Plain English.