Saturday, 3 August 2013

Deposit Insurance Schemes: Proposals and Comments

A Bank Run on Northern Rock
Although Cyprus has managed not to set itself as a precedent for the rummaging of deposits less than 100,000, it has spurred an interesting discussion on whether deposit insurance is a good policy or not. Many have been arguing that the time has come when we no longer need such schemes and depositors are to be considered as investors. Others claim that without deposit insurance things would turn to the worse. Arguments on both sides of the story run as old as the history of the deposit insurance itself, which dates back to the early 19th century in the US, when the New York state fund was started; the second try of such insurance was in the early 20th century with the Oklahoma guarantee fund. Both programs were ceased when, in the words of the FDIC in 1953, "the great majority of state chartered banks became national banks". Nevertheless, both these issues were viewed positively by the FDIC, in several 1950's reports. (for a more detailed view of the history of deposit insurance, the Cato Institute provides an excellent review)

The main cause of failure of the first scheme was that very few had any knowledge of its existence at the time when it was functioning. As for the latter, it was the fact that it protected much more than it should have, leading banks to pursue aggressive policies which increased deposits dramatically (the report states that the largest bank in Oklahoma raised its deposits base eightfold in just a year). As "customary" when banks end up with too much liquidity in their hands, they lent it to real estate and oil speculators, including officers of the bank. This led to 121 state bank failures in 10 years, more than 12 times the number of national bank failures. Other deposit insurance schemes in the early 20th century, organized mainly by US states, experienced similar failures.

The current form of the deposit insurance scheme arose out of the desire to limit the probability of bank runs, similar to the ones experienced in the Great Depression, occurring. The FDIC was created by the banking act of 1933, and as of 2013 it protects deposits of up to $250,000 in 7181 institutions throughout the United States. In Europe, Directive 94/19/EC of 1994 required all Member-States to have a deposit guarantee scheme of at least 90% of the deposited amount, up to at least 20,000 per person. In 2008, this minimum was raised to 50,000 and in 2010 to €100,000 and 100% of the deposited amount up to that including a 50,000 for investments (HT to Frances Coppola for this).

The rationale behind insurance plans is that panics and bank closures are costly to the economy and subsequently to the citizens and the state. Thus, if the incentive to withdraw funds from a banking institution in trouble can be removed, the economy will function more smoothly without imposing any more strain to the financial system.

Nevertheless, both academics and non-academics are occasionally critical of the deposit insurance scheme. Charles Calomiris, in a 1990 paper, comments that deposit insurance relies heavily on "the full faith and credit of the federal government". In addition, current schemes in the US, in contrast to the earliest versions of insurance plans, do not restrict interest payments to depositors, require a trivial proportion of capital to deposits (compared to more than 10% in many older schemes) and banks can maintain higher leverage with the purpose of attracting more customers with higher interest rates. Others, promote the view that many bank runs are not pooling equilibria (i.e. everybody trying to pull their money from the banking system) but rather separating equilibria (i.e. trying to move their money from "bad" banks to "good" banks); their argument is that the Great Depression bank runs occurred mostly because people feared that the state would be the next to fail.

Non-academics also appear to believe that abolishing state insurance would mean that banks will have to be more careful about they way they operate, thus making the banking system more stable than before. Another case about depositors having to understand that deposits are investments and they should not feel that their money is safer in a bank than in an investment fund has been made and issues on whether just providing liquidity for banks facing troubles (like the now notorious ELA mechanism) would be better for safeguarding the financial system from frictions have been discussed, with many beginning to think that their savings are not as safe as they believed.

What most of the above arguments do not account for, is the inability of the "everyday" person to understand which bank is likely to face trouble and which is not. "Bad" banks and "good" banks are not easy to be distinguished, even if you are an economist. Annual reports are so lengthy and complicated (the Citigroup annual report is about 300 pages) that 99.9% of people cannot make sense of it. Even those who do understand what goes on in a bank just by reading its annual report, have much difficulty in providing forecasts. For example, how many forecasters foresaw that Lehman Brothers would collapse in 2008, other than David Einhorn? Even if they did, how many were willing to believe them and act upon their advice? (in fact Einhorn was severely criticized when he stated that Lehman would face trouble). Sometimes, not listening to predictions can be good as well: economists are known Cassandras (it was Paul Samuelson who said: economists correctly predicted 9 out of the last 5 recessions) and thus their advice is rarely valued. In addition, insolvency is difficult to distinguish from illiquidity when markets are frozen, even from the Central Bank point of view. If the Central Bank, with all its resources and expertise cannot be certain of the viability of a banking institution how can an investor, or even worse, a depositor, distinguish between which bank is good and which is bad?

Thus, we reach the conclusion that we can only understand when a bank is "bad" after the event has occurred. Then, imagine a person who has a deposit of 10,000 in a bad bank. If he knows that his money will be lost in the event of a bank failure, it would be better for him to withdraw it; and fast too, since others share the same feelings and the bank may be left without any hard money any moment soon. Thus, even though his incentive is just to remove the money from the "bad" bank, he has no incentive to deposit it elsewhere, since he does not really know (and to be fair no-one does) if the failure of one bank will lead to the failure of another. Although this may appear to be a separating equilibrium to theorists, a disincentive to deposit the funds he withdrew exists (and we haven't even considered psychological reasons of the "I do not trust banks anymore" kind). Thus, this is not just a shifting of funds from one institution to another: it is the exit of funds from the whole banking system, turning the separating equilibrium to a pooling one. If one takes into account the multiplier effects then the effects of the money exiting are even larger.

Providing liquidity to ailing banks if no deposit insurance scheme exists is the idea which could possibly support the system by in effect never allowing banks to fail. Nevertheless, this is exactly the kind of policy which provides the banks with the incentive to promote loans for speculative deals, regardless of the risk. If the banks know that they will face no trouble with liquidity, then why not invest in high risk, high return opportunities? Exactly like the Oklahoma state fund, history will be repeated, and even worse perpetuated, as this essentially guarantees that no bank will ever fail. Banks will become the most lucrative investments ever: high return, zero risk of defaulting. This means that if we currently have 3 banks then we are destined to live with those 3 banks forever, unless by some change of fate more banks enter the sector and these 3 are forced into miniscule market shares (which again, will not mean that they will fail; their market shares will just reduce). However, if an effective oligopoly is enforced in a market, what is stopping the participants from forming a cartel and keeping every possible competitor out? Nothing at all, especially if they know that they are too big to fail. What they are suggesting is in essence replacing an idea which distorts some incentives with one which distorts them even more.

A reasonable alternative which Frances Coppola proposed and I second, we have to distinguish between which bank is about to become a zombie and who will be healthy again once we throw some money at it. Taxpayers cannot support the banking sector's troubles, the central bank should. Essentially, in contrast to the former paragraph, this proposal means that banks should be allowed to fail. If so, then the trouble of bank runs, without deposit insurance becomes immediately higher. The recent example of Northern Rock has proven that although almost 80 years had passed since the Great Depression, people still rush to their banks when they believe that their money is in danger. Yet, although the run on physical money is rough on banks, wholesale runs are even harder. When individuals or corporations transfer funds in large quantities from the bank, it leaves the latter with liquidity problems. This, in the Eurozone is supported (most of the times) with ELA funding. Needless to say that the Laiki example exemplified what too much ELA can do to a country. Consequently, if terrified depositors make a run, the Central Bank will have to support the bank (if it does not want to wreck havoc in the markets and public) before even knowing whether the bank is going to be healthy even again.

What the careful reader should have realized by now is that the reason deposit insurance appears to work in the United States and not in Europe is exactly "the full faith and credit of the federal government". Let us not forget that financial crises, are "essentially failures of market confidence". When a Eurozone member guarantees that it will pay if a bank fails, it essentially makes a pledge to take a loan to repay what it will de jure owe to depositors. Nevertheless, the Eurozone country is constrained by it's existing debt burden, its current GDP and the amount of deposits it has to repay, while the US is basically unconstrained. Any amount of losses in the US system can be replenished by having the US Treasury create more money; just like it did with TARP in 2008. None of the Eurozone countries has this opportunity.

One of the most astonishing aspects of this discussion is that those who promote a revision in the deposit insurance scheme are scarce. The only person (to my knowledge) who had so far suggested that we do want a deposits insurance scheme but we should monitor the incentives it creates via regulation is Anat Adamati (at 21:30 of the interview). This crisis has been as much an outcome of distorted bankers' incentives as of lax and inefficient regulation; something which seems to be forgotten as we tend to blame the "bad bankers" for this, not remembering that those who monitor them should have done a better job.

It is, however, beyond doubt that the deposit insurance scheme in Europe needs revision, with the first issue being the definition of the Lender of Last Resort. As the Member States cannot issue any currency it is up to the EU (and subsequently the ECB) to assume that part, so that deposit insurance is not dependent of a state's ability to assume more debt. Continuing, the imposition of harsher regulations on the banks (e.g. more capital requirements, with 30-50% being the range more favoured by most) as well as a mandatory annual contribution relative to the size of their assets and a clear rule on which bank should be considered as insolvent would mean that the severity of crises would be lessened, with depositors not fearing for their money every time they see bad news about their bank.

Most importantly, what now appears to be largely forgotten by regulators and policymakers (and by most discussions on the subject as well) is that size matters: it takes much more money to compensate Deutsche Bank's (if and only if you allow it to fail that is) depositors than Laiki's. Thus, controlling for banks never reaching the too-big-to-fail level provides another, albeit indirect, source of stability for the deposit insurance scheme: if a small bank fails, the effects are minimal. If a large one does, then taxpayers will most likely have to pay the price of the wrongdoings.


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