Examining the menace of bank deposit insurance

Martin van Staden / Midjourney
Martin van Staden / Midjourney

Insuring the money deposited in a bank so that you do not lose it if your bank goes insolvent, has seriously negative economic effects. The extent of these negative effects far out-weighs any possible positive effects of all other banking regulation cumulatively. Whilst this may seem counter-intuitive, it has been the world’s recorded experience since bank deposit insurance was first introduced in the United States of America in 1935.

Deposit insurance does nothing whatsoever to reduce bank losses or to enhance banking stability. It is merely a way of collectivising bank losses. By the introduction of what is known as ‘moral hazard’, deposit insurance makes banking considerably less stable and accentuates boom-bust cycles.

Debate about the evils of bank deposit insurance has recently been reignited around the world by the astonishing response of the American banking regulators to the closure of the Silicon Valley Bank, First Republic Bank, and Signature Bank. In South Africa, this debate has been accompanied by deep concern following our own Reserve Bank and Treasury having pushed through legislation to establish yet another state owned enterprise, this time in the form of the “Corporation for Deposit Insurance” or “CoDI”.

On a Friday in March last year, Silicon Valley Bank was shut down and the US Federal Deposit Insurance Corporation (FDIC) was appointed receiver. The following Monday the FDIC stated that “today the FDIC transferred all deposits—both insured and uninsured—and substantially all assets of the former Silicon Valley Bank … to a newly created, full-service FDIC-operated ‘bridge bank’ in an action designed to protect all depositors of Silicon Valley Bank… All depositors of the institution will be made whole.”

The FDIC decided to guarantee both the insured and the uninsured deposits at Silicon Valley Bank and New York’s Signature Bank by using federal “systemic risk” emergency powers. FDIC’s insurance limit is ordinarily $250,000 per depositor. It has now “made whole” depositors with tens of millions of dollars in deposits.

Since then, speculation has been rife that full depositor protection is now perforce the de facto policy of the United States Federal Reserve.

The problems created by government-mandated deposit insurance have long been recognised by economists around the globe.

The American Institute for Economic Research describes the well-documented pitfalls as follows: “Deposit insurance generates moral hazard. That is, an incentive to engage in more reckless conduct when one’s misdeeds are to be paid for by someone else. Bank managers tend to make riskier loans and investments than they would without insurance, and depositors worry much less about their lending practices, and therefore the financial stability of the banks they patronise.”

Moreover, regulators too become inevitably lulled into greater levels of complacency and slack enforcement.

In March 1933, US President Franklin Roosevelt said: “I can tell you that the general underlying thought behind the use of the word ‘guarantee’ with respect to bank deposits is that you guarantee bad banks as well as good banks. The minute the government starts to do that, the government very probably runs into losses…. We do not wish to make the United States Government liable for the mistakes and errors of individual bankers and to put a premium on unsound banking practices in the future.”

Yet that is precisely what has happened, again and again over the almost century since.

Government-sponsored deposit guarantees generate moral hazard. This fact is well-established and simply no longer open to informed debate. That is, such deposit guarantees engender riskier behaviour in the banking sector. Bank deposit insurance does not guarantee bank profits, but it cannot help but incentivise bankers to take greater risks, knowing that depositor losses will be made good to the limit set by the government.

After observing regulators’ latest responses to the collapse of Silicon Valley and Signature Bank, it is understandable for the market to conclude that deposit insurance in the United States has over time systematically led to there no longer being an upper insurance limit. Riskier future investment decisions by banks therefore become inevitable, and likely fuel yet more severe boom-bust business cycles.

These risks have been building up over time with every increase in deposit insurance limits.

Silicon Valley’s sin was to invest excess deposits in what is supposedly one of the safest financial assets in the world: US treasury bonds. It was encouraged to do so under the risk-weighting rules of ostensibly clear-sighted Basel regulators. Some of these securities have lost over 20% of their value as a result of the Federal Reserve raising interest rates in an effort to tame the inflation brought about by its own zero rate, ‘quantitative easing’ policy.

This could have been a theoretical paper-loss only. However, the banks had to realise those losses by selling these securities to pay out depositors who were fleeing because of the perception of just such a lack of liquidity. The banks had thus been exposed to severe interest-rate risk (also known as duration risk) by the Federal Reserve itself.

Economics Professor Lawrence H White of George Mason University testified to the US Congress in 2011 that Federal deposit insurance, since its birth in the 1930s, has meant that a comparatively risky bank with less adequate capital to cover potential losses, no longer faces a penalty in the market. Depositors have no incentive to shop around for a safer bank, so they no longer demand a higher interest rate for their deposits.

Attempts to price deposit insurance according to risk, so as to recreate a penalty for holding a riskier bank portfolio, were mandated by the FDIC Improvement Act of 1991, but that attempt has failed. The FDIC insurance fund has now been exhausted by US bank failures and at present has a large negative balance. US taxpayers are on the hook for the morally hazardous banking that the FDIC itself has engendered.

“Some way of rolling back and ultimately ending federal deposit insurance must be found…” Professor White told Congress.

The US banking system has been weakened by state privileges. Taxpayer-backed deposit insurance and ‘too big to fail’ bailouts generate moral hazard. Banks take advantage of these guarantees by holding asset portfolios too full of default and duration risk and finance their portfolios with too much debt and not enough equity. Rather than trying to come up with another fix, Professor White testified that Congress should seek to dismantle that which has left the American people saddled with an unhealthy banking system.

The very concept of ‘deposit insurance’ is in fact approaching fraudulence. How does one “insure” an entire industry that by its very nature is inherently insolvent?  By increasing the FDIC insurance limit over time since the programme started, the US federal government has itself been responsible for generating ever greater morally hazardous banking practices.

Since March, 2023 there appears no longer to be any effective limit to deposit insurance in the United States. The FDIC now fully protects all depositors, both insured and uninsured, with the US Department of the Treasury making available up to $25 billion from the Exchange Stabilization Fund. In addition, the Federal Reserve has found it necessary to create a new “Bank Term Funding Program” offering collateralised loans to distressed financial institutions.

The next time a bank is in a similar position as Silicon Valley Bank or Signature Bank, depositors will naturally expect identical treatment from regulators. Political pressure for such treatment will be unrelenting. (It is thought that hundreds of US banks could be nearing similar positions). If bank executives act as though full depositor protection is now the order of the day, moral hazard will increase markedly, and riskier investment and operating decisions are inevitable.

Creating moral hazard through deposit insurance does not prevent banking instability; it simply pushes the problem into the future and on to society as a whole in due course. Because of “too-big-to-fail” bailouts and “systemic-risk” deposit guarantees, ordinary people (bank clients and taxpayers) are paying the price for the resultant moral hazard from distorted investment and regulatory decisions, and the resultant never-ending boom-bust economic cycles.

The ghastly truth is that the world’s superpower central bank has made such a mess of affairs that it has had to choose between two poisons: Either capitulate and allow inflation to run ahead, or allow the banking crisis to reach systematic proportions. It has chosen the latter, culminating in yet another boom-bust cycle, a violent lurch from ultra-easy money to ultra-tight money.

US economists say that it is past time to abolish state-underwritten deposit insurance. In South Africa, we still have time. If not, it will be no source of pleasure for analysts to say in the not far distant future: “You were warned!”


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The views expressed in the article are the author’s and are not necessarily shared by the members of the Foundation. This article may be republished without prior consent but with acknowledgement to the author.




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