A New Approach to Deposit Insurance

Guest Post by Frances Coppola and Euronomist

Recent developments in the Eurozone, specifically Cyprus where the first EU-dictated bail-in of bank depositors took place, brought to light an important issue which had been hiding in the shadows: the flawed nature of current deposit insurance schemes.

Some advocate abolition of deposit insurance because it distorts incentives for banks and savers. But others believe that it is necessary to avert panic every time a bank nears its inevitable death. Yet although the two ends of the spectrum appear to disagree on the specifics of their proposals they both agree that the deposit insurance scheme needs to change if we want the future of both the financial sector and the wider economy be brighter than the present. In this article we present and develop a scheme which will address the need of depositors for safety without creating distorted incentives, while simultaneously helping to ensure the viability and stability of the banking sector in time of crisis.

A flawed scheme

The main purpose of the deposit insurance scheme is to safeguard depositors in the event of a financial institution’s bankruptcy. In addition, by guaranteeing the funds in a person’s account it prevents panic from spreading in the economy, with horrified citizens rushing to their banks so that they can withdraw their hard-earned money. Nevertheless, it has disadvantages. When banks do not have to fear for their customers’ funds they may indulge in risky speculative deals which destabilize both the bank itself and the economy in general. This is not pure speculation:  in one of the first deposit insurance schemes, bank failures actually increased due to increased liquidity and terrible choice of investments (notably real estate).

While the success of the deposit insurance scheme mainly depends on the good reputation and financial strength of the state backing it, bank failures can be costly to the economy. The cost to the state of large bank insolvency can be billions of currency. This amount has to be generated either by increasing taxation or by additional Government borrowing, which in turn will require increased taxation or reduced government spending which, depending on the state of the economy, may result in a severe recession. Governments that have currency-issuing capability may alternatively opt for printing money, which means that the taxpayer will essentially be paying for the bank’s failure through reduction of real buying power. In the financial crisis of 2008, taxpayers paid for the mistakes of bankers. The direction of discussion ever since has been around how to limit the consequences of bank failure for taxpayers by forcing bank creditors to bear more of the cost. The bail-in of Cyprus depositors and the haircut suffered by depositors in the UK’s Southsea Bank failure were such attempts, but the price that may be paid for this is greater likelihood of damaging large deposit bank runs and/or disintermediation of the banking system, introducing even more funding fragility for banks and increasing their reliance on the central bank.

Yet abolishing deposit insurance could have terrible consequences. In the event of a major bank failure, with thousands of people losing their money, a mass bank run with disastrous effects on liquidity and asset prices would be likely. In the absence of deposit insurance a single bank failure may escalate into a systemic crisis, followed by a major recession with money becoming a scarce resource. This has already happened before, in 1930, when, in the US, 744 banks failed in the first 10 months of the year, with more than 9,000 failures in the subsequent decade. Even though we have progressed in many respects since the 1930’s, convincing someone that his or her money is safe in the bank when a friend of theirs has lost everything in a bank failure would be difficult. Anyway, the depositor may be right: the repercussions of one bank’s failure may cause another to go bankrupt even if no withdrawal of funds is made.

Although the deposit insurance scheme bears the name “insurance”, it does not resemble normal insurance policies. When someone wants to insure a house or an automobile an amount of money – the premium - has to be paid in advance in order for the insurance company to assume the risk of compensating the owner if something goes wrong. This, however, is not the case with deposit insurance: the depositor does not have to pay any amount of money as a premium for having the deposited funds insured by the state. Instead, in European countries, the state imposes a levy on banks to cover the cost of anticipated deposit insurance claims. Bank depositors unwittingly pay for this through lower interest rates on their savings: but the burden is also shared by borrowers through higher interest rates, employees through lower wages and shareholders through smaller dividends. And in a systemic crisis, the insurance fund is never enough anyway. The UK’s FSCS was topped-up by state funding in 2008 and has had to repay that through additional levies on the financial institutions that did not fail – hardly an encouragement of sound financial management.

Nor is the state necessarily obliged to honour deposit insurance. Iceland refused to honour deposit insurance for foreign depositors in its banks. The UK and the Netherlands challenged this in the EFTA court and lost their case. At present, no European sovereign is obliged to honour deposit insurance in a systemic banking failure. Fortunately for the stability of the European banking system, this is not widely known: but the first Cyprus bail-in proposal, which would have partially bailed-in small depositors who were supposedly protected by deposit insurance, depended on it.

A new proposal

Our proposal is that depositors should explicitly pay a premium for the benefit of having their money insured. We limit this to interest-bearing accounts, because we consider non-interest-bearing (transaction) accounts to be a social good which should be protected by government without further cost to citizens. We propose therefore that transaction accounts would continue to be insured without explicit charge, but would no longer bear interest: insurance for transaction accounts would continue to be paid by bank levy.

Some might believe that insurance for interest-bearing accounts could be entirely provided by the private sector. But recent events suggest otherwise: when AIG became the largest underwriter for sub-prime mortgage CDS’s, nobody thought it would face trouble; the company was (and still is) one of the biggest insurers in the world. Yet, when the whole charade collapsed in 2008, AIG would have gone down with it if the US government had not bailed it out. Even insurance agencies which focus on extreme catastrophes like hurricanes, earthquakes, etc. would have trouble repaying the billions needed when it came to a systemic bank failure. In addition, private insurers would have an incentive to keep that money employed in projects so it could receive a high rate of return to make up for the costs of running the business: this runs the risk that in the event of a major bank failure the funds would be tied up in other investments with no immediate means of realising them, which would bring the insurer down with the bank and force the state either to repay the insured depositors itself or let them take the fall. Neither of these options is a good one, and we would thus prefer the state to assume the role of the insurer itself.

When we talk about the state, we usually mean government. But in this case we think the role of the insurer should fall to the Central Bank. There are two reasons for this:

• The Central bank is (theoretically) independent of political agendas and has more access to classified banking data than any other agency. This would allow the Central Bank to perform a better analysis of the probability of an institution failing, thus making the insurance premiums commensurate with the realities of the banking industry.

• The ability of the Central Bank to create unlimited liquidity would enable depositors to access their money in a systemic crisis without causing fire sales of assets and price crashes setting off a rapid deflationary spiral as happened in 2008.

Since in many countries the Central Bank is also responsible for prudential regulation of the banking industry, care would be needed to ensure clear separation of function to avoid conflict of interest. This would be best achieved by maintaining the insurance fund as a separate legal entity with its own management under the Central Bank umbrella.

Transparency would also be important. The fund’s management should be obliged to make public every quarter the size of the fund, the amount of deposits it insures and provide an annual report signifying the events of the past year. In addition, the fund’s financial statements should be audited by independent auditors.

As this fund would be literally a pool of money, the following questions arise:

1. How should this money be invested so that it remains safe and is available when required?
2. What should happen if the accumulated amount of insurance premium became disproportionately large in relation to the value of deposits to be covered?

Regarding the first question, it would be extremely unwise for deposit insurance funds to be placed with the banks whose deposits it was intended to insure, or with other institutions that depend on those banks. Therefore it would probably be sensible for the fund to be restricted to investments in safe assets such as high-quality government debt. Central banks already have lists of acceptable collateral for funding and these would be a good start point for acceptable investments for the insurance fund, although the insurance fund’s list might need to be more restricted. In any event, there should be an explicit commitment from the Central Bank to top up the insurance fund should it suffer losses due to asset failure, including the failure of its own government’s debt. For Eurozone countries whose central banks are unable to create money, it might be wise to use the ESM to top up deposit insurance funds, with the ECB standing as insurer-of-last-resort in the event of the ESM being unable to cover the losses. Ensuring the safety of insured depositors and the stability of the banking system is more important than political arguments over whether or not this would constitute monetization of state debt.

Regarding the second question, it is of course necessary for an insurance fund to have a safety margin in excess of expected claims. This would be invested in safe assets in the same way as the rest of the fund. However, if the excess became too great it could be returned to depositors either as a reduction in future premium payments or as a tax credit. The premium is, after all, effectively an hypothecated tax on savings.

We are now reaching the most important part of the analysis: who should receive deposit insurance, how much that insurance should cost and what the insurance limits should be. The key points are:

• Transaction accounts would be fully insured for no charge, but would no longer bear interest.

• All interest-bearing deposit accounts would be subject to an insurance premium which would take the form of a marginal reduction in the interest rate.

• On interest-bearing accounts, customers will have the option of refusing deposit insurance, in which case they will receive a higher rate of interest but will not be protected in the event of bank failure.

• There would be no insurance limit on interest-bearing accounts. However, we would recommend a tiered insurance premium structure: deposit insurance premiums should be higher for larger amounts and higher interest rates, to reflect the increased risk they represent and discourage routine placing of large sums in insured deposit accounts as an alternative to other safe assets.

• There would also be no insurance limit on non-interest-bearing transaction accounts. However, there would be a time limit on the account, beyond which funds in excess of a certain amount (possibly the current deposit insurance limit) would be automatically swept into an interest-bearing account.

To ensure transparency and avoid mis-selling, account opening procedures will need to be amended. On account opening, the bank should offer the depositor three options:

• A non-insured account with an interest rate of X

• An insured account with an interest rate of say (1-0.075)*X

• An account without an interest rate (transaction account)

The costs, benefits and risks of all three should be clearly explained. Additionally, it should not be possible to open a non-interest-bearing transaction account without also opening an interest-bearing account, either insured or uninsured.

Under the present deposit insurance scheme, the amounts insured are limited. There may be a view that insurance limits should continue under this scheme too. But we think the risk of destabilising runs on large deposits is sufficiently great for this not to be a wise decision. The imposition of capital controls in Cyprus to prevent large deposit runs has been economically damaging and we think it would be better to remove the incentive for large deposits to run. We suggest therefore that there should be no limit to the funds that can be insured in interest-bearing deposit accounts, but that higher insurance premiums should be charged for larger deposits to encourage investors to place funds elsewhere. Unlimited insurance on interest-bearing deposit accounts (for a price) would still give large investors an alternative to government debt as a safe asset, which in a market panic could help to ensure the stability of the banking system.

In the case of accounts with no interest rates (principally transaction accounts) we also propose that the amount insured should be unlimited. This is because the current EUR100,000 limit in the European deposit guarantee scheme is far too low for many corporate and some individual depositors. Corporate payrolls, for example, can be far in excess of the EUR100,000 limit and are in no sense “savings” – they are people’s wages. People buying and selling houses may also have funds far in excess of the limit going through transaction accounts, and would face homelessness if these funds were lost due to a bank failure while they were in transit. The US’s FDIC limit is $250,000, but even this is insufficient for some depositors. Loss of funds “in transit” can have terrible social and economic consequences, and we think therefore that deposit insurance should cover them regardless of the amount. We therefore propose, instead of an insurance limit, a time limit for funds in excess of the current deposit insurance limits. Funds in excess of this amount may remain in an insured non-interest-bearing account for e.g. 60 days, after which they would automatically be “swept” into an interest-bearing demand deposit account and insurance would be charged unless the depositor has opted out of insurance on that account.

Concern has been expressed that unlimited insurance would lead to abuse of transaction accounts by large investors seeking safety. However, we think this concern is unfounded. Under normal circumstances, a large investor would prefer interest-bearing safe assets over a non-interest-bearing insured account. Only under exceptional circumstances – say a debt crisis where safe assets were no longer “safe” – would an investor forego interest for safety. And under these exceptional circumstances, it would be sensible to allow them to do this in order to head off destabilising runs and ensure the stability of the financial system.

In conclusion....

We would like to remind the reader that the current state of the deposit insurance scheme is far from ideal. We have proposed an alternative which we believe would protect depositors from losses and prevent destabilizing bank runs without causing moral hazard for banks and the prospect of unsupportable losses for the state.

How we got here:

Sowing the wind – Coppola Comment
Sham guarantee – Coppola Comment
Anatomy of a bank run – Coppola Comment
Cleaning up the mess – Coppola Comment

We could have seen this coming. Or couldn’t we? - Euronomist Blog
Deposit insurance schemes: proposals and comments – Euronomist Blog

This post can also be found at Pieria.

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.