Before federal deposit insurance, people worried more about bank failures than now. If you had money in a bank and it went broke, you might lose everything. That danger motivated people to monitor the financial state of their banks.
But banks did fail. People were hurt, with the damage spilling over from the specific households involved to the economy as a whole. So we established the Federal Deposit Insurance Corp. to protect small depositors. That not only provided protection to individual depositors but quieted public fear, helping to stabilize the national economy.
In subsequent problem periods, such as the early 1980s when some banks were farm-dependent, the savings and loan crisis later that decade or the smattering of failures recently, the issue of moral hazard re-emerges. Does deposit insurance induce such complacency that bankers lend recklessly, free from worrying about depositors pulling their money out?
It is a legitimate question. Moral hazard clearly played a role in the SL debacle.
Should we then abolish the Federal Deposit Insurance Corp. to encourage depositors to keep their eyes on their nest egg? Would this really keep bank managers on the straight and narrow?
I am skeptical. The existing system is a workable compromise because it recognizes two complications overlooked by anti-regulation enthusiasts.
First, information is not cost-free. If everyone had to monitor the management of the bank where they keep their money, society collectively would spend a lot of time and money doing so. Those are resources the current system frees for other uses.
Yes, if it were not for government deposit insurance, private insurance might develop. Banks would pay for private insurance to make themselves more attractive to depositors. Those that refused to procure private deposit insurance would see their deposit base wither away.
But private insurance would inspire less public confidence than the FDIC because private firms would be smaller and more vulnerable to an economy-wide financial crisis. Moreover, private firms would not have access to the U.S. Treasury, which is the ultimate backstop for the existing system.
Yes, private firms that would specialize in monitoring banks for a fee might also spring up, filling a role analogous to Dun and Bradstreet for small businesses or Moody’s and Standard & Poor’s for municipal and corporate bonds.
I wouldn’t count on it, however. Such institutions did not spontaneously arise before the 1930s. One problem: If banks did not pay to be rated as bond issuers, it would be hard to prevent free-riding. If the rating company charged for its reports, keeping the information therein from being splashed across the Internet would be a challenge. It might be impossible to generate enough in fees to pay the costs of monitoring banks effectively.
It is instructive that such firms have not sprung up to sell risk-rating information to the large depositors for whom the $100,000 FDIC limit is small change. Large depositors in IndyMac may lose half of their balances above the $100,000 limit. But apparently, most of them were oblivious to the danger they ran.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.