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Is deposit insurance the problem?

Raghuram Rajan, who was extremely prescient in predicting that the deregulation of the financial sector would lead to a global economic crisis, doesn't think regulating the size of banks is the way to go. It's too difficult to do, he says, and size has some advantages. Trying to control activity is also difficult. His suggestion is much more radical:

In reality, proposing limits on size and activity is just an attempt to diminish the deleterious effects of another previous and now anachronistic intervention – deposit insurance. When households did not have access to safe deposits, deposit insurance made sense. With the advent of money-market funds, households gained access to near riskless deposits. Money-market runs can be eliminated by marking them to market daily; they do not need deposit insurance.

To encourage community-based banks, deposit insurance may still make sense because small banks are poorly diversified and subject to bank runs. But for large, well-diversified banks, deposit insurance merely contributes to excess. We will bail out these banks anyway in a time of general panic. Why encourage the poorly managed ones to grow without market scrutiny by giving them deposit insurance along the way? Why not phase out deposit insurance as domestic deposits grow beyond a certain size? That would be far more effective in reducing risk than size or activity limits, and far easier to implement.

Outside of what a hard, hard sell this would be, is it a good idea?

By Ezra Klein  |  January 26, 2010; 4:48 PM ET
Categories:  Financial Regulation  
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On the surface it sounds like a great idea.

When I first read the headline, I thought it referred to getting rid of all deposit insurance, which is an idea the Economist and various libertarian-minded sources have been pushing for years.

But just removing it as a bank gets excessively large, I think, would place a defacto limit on how large banks are able to grow. Which makes sense. As Robert Reich said last night on PBS Newshour, no free market economy should ALLOW a business to become too big too fail. It just makes no sense.

Posted by: Jasper99 | January 26, 2010 4:54 PM | Report abuse

What happens when the value per share (Marking to market) falls below $1.00?

Posted by: original_hewald | January 26, 2010 5:00 PM | Report abuse

Either that or as insurer require the 30% capital that banks used to keep before they had deposit insurance.

Posted by: jwogdn | January 26, 2010 5:10 PM | Report abuse

Yes lets remove the thing has stopped bank runs from being a common occurrance.

Posted by: endaround | January 26, 2010 5:18 PM | Report abuse

Didn't one of those "near riskless" money market funds break the dollar back at the peak of the 2007 meltdown? Hm.

Posted by: scarpy | January 26, 2010 5:18 PM | Report abuse

If the big banks will get bailed out anyway, isn't the deposit insurance implied? In that case shouldn't the banks be paying at least something for that?

Posted by: ideallydc | January 26, 2010 5:20 PM | Report abuse

This is insane. My bank is only offering 0.7% interest right now. I keep my money there not because of that interest, but because I want an ironclad, government-backed guarantee that my savings are safe. If you take away deposit insurance, then my bank deposits are no safer than putting money into financial stocks. So I might have an incentive to shift from bank deposits to stocks, or from American bank deposits to foreign bank deposits, but I have no reason to keep any money in an American bank.

Posted by: tomveiltomveil | January 26, 2010 5:22 PM | Report abuse

Allow banks to grow as large as they want, with the benefit of federal deposit insurance.

Also allow them to expand into investments and everything they want -- BUT NOT BOTH. If they do decide to engage in the risky stuff, they should be ineligible for deposit insurance.

Consumers who don't want risk should be encouraged (not mandated, but educated) to put money in a "Bank Classic," a la pre-1999 banks. These institutions would voluntarily regulate, and support transparency to prove they're complying, or else lose their FDIC support.

Investors should be allowed to invest, but they should accept risk. Financial businesses should be allowed to manage investments, but the US taxpayer shouldn't be on the hook for insuring investor losses!

What we have now is a financial industry trying to have their cake and eat it too. They want freedom to gain from risky investments, but they want socialized protection from losses. What a great deal for them! But it's unfair to the taxpayers.

Posted by: billkarwin | January 26, 2010 5:32 PM | Report abuse

Lawrence Lindsey, one of Bush 43's economic advisors, made the best argument I've heard in favor of deposit insurance at a tax conference I attended a few years ago: In theory, depositors could make rational decisions based on their bank's level of risk. The problem is that there is no information on that level of risk in between quarterly financial statements. With no access to current information, deposit insurance becomes a necessity. Otherwise, any financial institution, no matter how large, can be subject to a run based on rumor. Think of how much government cash it would take to stop a run on Citi or Chase.

Posted by: davidleetodd | January 26, 2010 5:38 PM | Report abuse

I found myself wondering the same thing ideallydc mentioned. If I know my money is safe in the bank, it does not matter as much to me if my bank is looking less secure. But if there is no such assurance, I take my money out at the first whiff of trouble, if enough people do the same, we cause a run on the too-big-to-fail bank. I don't see the gain after all, the alternatives are still bank dominoes on the one hand, or a safety net on the other.

I guess depositors could, if this was enacted, just be to frightened to bank with the big guys in the first place, is this the idea? Please set me strait if I am missing something.

Posted by: whseitz | January 26, 2010 5:39 PM | Report abuse

"Outside of what a hard, hard sell this would be, is it a good idea?"

It can't be any worse an idea than letting big banks play roulette with taxpayer money via federally insured deposits. They win, they keep all the profits. They lose, they are guaranteed a bailout. But isn't the Volker plan intended to limit the ability of banks to do this in in the future?

At any rate. Insured deposits are not so bad so long as those deposits are safeguarded by conservative reserve ratios and other regulations designed to insure that those deposits are not endangered by the sort of shenanigans and chicanery our financial institutions have been engaged in of late. Reinstitute Glass Steagal and let the investment banks fail the next time. Good riddance.

Posted by: bgmma50 | January 26, 2010 6:07 PM | Report abuse

If not for deposit insurance, do you think we would have gotten through September 2008 without a general run on the banks?

Posted by: adamiani | January 26, 2010 6:30 PM | Report abuse

First, on deposit insurance generally. There is an extensive economics literature on this subject (on which I'm not even remotely qualified to speak) but that is summarized in the beginning of this paper. "Thus, according to economic theory, while deposit insurance may increase bank stability by reducing self-fulfilling or information-driven depositor runs, it may decrease bank stability by encouraging risk-taking on the part of banks."

The idea of insuring deposits by firm rather than account becomes problematic for a couple reasons. First, consumers benefit from economies of scale in banking (most obviously by end services like ATMs and online services that are better provided by national banks than smaller ones) so consumers may be willing to take the implicit deposit insurance (the too big to fail notion) rather than the inconvenience. Second, it would impose excessive information costs. Not only would individuals have to monitor their bank, but regulators would have to monitor the banks. In theory, this should be simple (how much is the bank carrying in domestic cash deposits), but there is little doubt it could get messier as regulatory rules are drawn up, and banks demand offsets for playing nice on certain provisions. Last, it would encourage market innovation to circumvent the rule. The history of American banking is one of thrifts, unit banks, state charters, bank holding companies, investment banks, and other creations that the market created to circumvent regulatory requirements, or that the regulators created to satiate the market. Whether we'd merely see an agglomeration of community banks, acting with common purpose and growing into foreign markets, or something entirely new, there would be ways around this idea.

Posted by: dgs290 | January 26, 2010 6:54 PM | Report abuse

Yes, it's a great idea.

And his point that we will bail the banks out anyway in a time of crisis is correct. Nobody seems to remember this, but the terrifying thing that was unleashed by Lehman was when the Reserve Funds--a major money market fund--broke the buck:

That is what made Paulson hit the panic button, and that's when they started gathering together members of Congress to demand massive, massive bailouts or suffer the collapse of our financial system.

But Rajan's core point is that the problem we have is too much wealth concentration. That is what's fundamentally driving the weakness in our financial markets and our economy overall, not regulatory issues. Deregulation doesn't help, and it reinforces the wealth concentration cycle, but regulatory issues are not the primary driver of any of our crises. Once we decided it was OK to allow non-rich people's wages to freeze in spite of profound economic growth, that's when the system started to get perturbed. And encouraging this wealth concentration on Wall Street has juiced paper earnings (which were slightly more equally distributed) at the expense of our economy.

Proposals like these are nice, but we need to start addressing the core issue of too much wealth concentration.

Posted by: member8 | January 27, 2010 9:38 AM | Report abuse

Well, as other commenters have said, if the big banks will be bailed out, they should be paying something for that.

Either they have absolutely no state guarantee, and must self-insure, and the state is prepared to allow them to fail, or the state isn't prepared to let them fail, and they MUST pay the full value of the insurance they receive from the state. The only thing anachronistic about deposit insurance is that it does not cover all possible sources of runs, such as short-term paper borrowings.

Posted by: albamus | January 27, 2010 10:23 AM | Report abuse

sure, taking out the firewall portion of the glass steagle act produced good results, let's get rid of the anachronistic FDIC part of the glass-steagle act too

people don't need their savings protected now that the government protects corporations

Posted by: jamesoneill | January 27, 2010 10:30 AM | Report abuse

How would this actually work? Would it apply individually to all the different banks owned by a bank holding company, in which case it would be meaningless (just set up a subsidiary)? Or would it apply in the aggregate (oops, your bank just got bought, I sure hope you read that little notice that got sent along in the statement, have fun ditching your credit/debit card and all your automatic bill-paying information)? Oh, and while you're at it, are your deposits insured by the Federal Deposit Insurance Corp, or by the Federated Deposit Insurance Corp, a brand-new subsidiary of AIG? (Big depositors would no doubt run due diligence, but regular depositors might not be able to keep track.)

It seems like a nice way to go at first, but under the hood I think it's a huge can of worms, and it doesn't actually address the features that make banks dangerous.

Posted by: paul314 | January 28, 2010 10:04 AM | Report abuse

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