Deposit Insurance Encourages Bank Failures Like SVB

Informed customers used to monitor banks’ risk management. Now they skirt the $250,000 limit.

By Charles Calomiris. Excerpts:

"A banking system dominated by government insurance, plus too-big-to-fail protection that effectively insures all deposits at the largest banks, lacks essential market discipline, is systemically unsafe"

"Historically, unprotected well-informed depositors, especially other banks, gauged and responded to each bank’s risk, creating an incentive for banks to manage risk responsibly. Uninformed depositors—like those now at risk at SVB—were free riders on informed discipline. Now, informed depositors can easily get around the $250,000 limit on insurance, which eliminates their incentive to monitor banks."

"bank regulators . . . often lack incentives and knowledge to measure and punish risk on a speedy basis."

"A century ago, bank regulators saw their job mainly as examining banks and forcing them to publish accounts in the local newspaper so that informed lenders and depositors could act on accurate information. Runs on deposits occurred under the old system, but the record of fragility has been exaggerated and misunderstood, and the U.S. historical experience was an extreme case. Most countries had occasional bank failures but rarely suffered a systemic crisis. Canada never did. The U.S. was prone to systemic crises because of idiosyncratic factors of regulation. Branching restrictions, which weren’t eliminated until 1997, created a system of thousands of small, isolated and undiversified banks and a pyramidal liquidity management system that sometimes collapsed under stress."

"Deposit insurance was absent from nearly all other countries’ banking systems before 1980, and from the U.S. (with some temporary exceptions) until 1933."

"Virtually every academic study of deposit insurance shows that it promotes, rather than reduces, banking system fragility, with major costs borne by the insurers—which means ultimately by insured depositors and potentially taxpayers."

"When discipline resulted in bank failure, that often had a bright side: Risky banks in receivership were prevented from digging deeper holes at depositors’ expense. Consequently, for most of U.S. history, depositors’ losses on failed banks were small."

"A new factor is the Federal Reserve’s quantitative-easing and interest-on-reserves policies, which have eliminated the interbank market for borrowing reserves, further reducing incentives for institutions to monitor one another’s risks"

"This episode points to a continuing failure of regulatory discipline, which lacks the incentives and smarts of the market, to substitute for market discipline. It also points to the need for business managers to learn more about banking, and for the Fed to learn that its own monetary-policy mismanagement for many years has lots of consequences for reducing financial stability."