Deposit insurance in theory and practice
| Published date | 01 January 2000 |
| Pages | 36-56 |
| DOI | https://doi.org/10.1108/eb025029 |
| Date | 01 January 2000 |
| Author | Richard Dale |
| Subject Matter | Accounting & finance |
Journal of Financial Regulation and Compliance Volume 8 Number 1
Deposit insurance in theory and practice
Richard Dale
Received: 2nd November, 1999
Department of Accounting and Management Science, University of Southampton, Highfield,
Southampton SO17 1BJ; Tel: 01703 592549; Fax: 01703 593232; e-mail: jpc@socsci.soton.ac.uk
Richard Dale graduated from the London
School of Economics and subsequently
qualified as a barrister-at-law at Lincoln's
Inn.
After working as a merchant banker at
NH Rothschild and Sons. Dr Dale won a
Rockefeller Foundation fellowship at the
Brookings Institute in Washington DC.
More recently he was a Senior Houblon
research fellow at the Bank of England. Dr
Dale is currently Professor of International
Banking and Financial Institutions at
Southampton University and Visiting Pro-
fessorial Fellow at Queen Mary and West-
field College, London University.
ABSTRACT
Having been hailed as the most important con-
tribution to stabilising the US financial system
after the 1929—33 crash, deposit insurance is
now being
blamed
for financial destabilisation,
particularly in emerging markets. This paper
focuses on the relationship between deposit
insurance and systemic stability in the banking
system,
drawing on recent experience in the
USA,
Europe and Japan. The conclusion is
that if there is an embedded perception that in
the last resort depositors will be protected
beyond insurance limits then market-orientated
solution to the problems of 'moral
hazard'
and
excessive risk taking cannot work.
INTRODUCTION
In 1959 Milton Friedman asserted that the
introduction of US federal deposit insur-
ance after the bank crisis of 1929—33 was
'the most important structural change in
our monetary system in the direction of
greater stability since the post-Civil War
tax on state bank notes'.1 Thirty-two years
later the US Treasury, in the aftermath of
another US financial crisis, concluded that
deposit insurance was at least partly to
blame:
'Events have demonstrated that some
criticisms levelled in the 1930s against
the idea of federal deposit insurance had
considerable merit. The system has subsi-
dised highly risky, poorly managed insti-
tutions. These institutions have exploited
the federal safety net by funding specula-
tive projects with insured deposits. The
resulting costs have been borne by well-
run institutions and by the tax-payers.'2
Outside the USA, recent experience with
deposit insurance has also been mixed. On
the one hand, in response to intensifying
banking disturbances in developed and
developing countries, more and more gov-
ernments have introduced formal deposit
insurance schemes: of 72 systems recently
surveyed by the International Monetary
Fund (IMF) no less than 50 had been intro-
duced in the 1980s and 1990s.3 Yet an IMF
study of banking crises around the world,
covering the period 1980-97, concludes
that 'explicit deposit insurance tends to be
detrimental to bank
stability'.4
Against this background this paper
Journal of Financial Regulation
and Compliance, Vol. 8, No. 1,
2000,
pp. 36-56
© Henry Stewart Publications,
1358-1983
Page 36
Dale
focuses on the relationship between deposit
insurance and systemic stability in the bank-
ing system. The first section examines the
nature of bank fragility; the second explores
the relationship between moral hazard and
deposit insurance; the third, fourth and fifth
sections examine deposit insurance policies
in the USA, the European Union (EU) and
Japan; and the final section provides a sum-
mary and conclusion.
THE CASE FOR DEPOSIT INSURANCE
Deposit insurance may be justified on two
separate grounds, namely the protection of
depositors and the prevention of bank runs.
The former may be viewed as an aspect of
consumer protection and is linked to the
presumed inability of ordinary depositors
to monitor the riskiness of banks in which
they place their funds as well as the poten-
tially severe cost of deposit losses to indivi-
dual savers. Of course, given the political
sensitivity of losses arising from bank fail-
ures,
formal deposit insurance may also be
used to limit the payout to depositors in a
situation where there would otherwise be
demands for full compensation.
The consumer protection rationale for
deposit insurance will not be further con-
sidered here. It is important to recognise,
however, that to the extent retail deposi-
tors are insulated from bank solvency risk,
there are unavoidable moral hazard pro-
blems of the kind discussed below.
The financial stability rationale for
deposit insurance is more troublesome —
and certainly more controversial. In order
to understand the issues here it is necessary
first to refer briefly to the debate on the
fragility of banks. In the context of this
debate it is possible to identify two polar
views:
between the view of George
Benston and George Kaufman and the
more general view that banking is inher-
ently fragile.
George Benston and George Kaufman
are associated with the idea that the private
banking and payment systems are not
inherently unstable.5 They argue that
'banking appears to be no more unstable
than most other industries', that 'the cost
of individual bank failures is relatively
small and not greatly different from the
failure of any non-bank firm of compar-
able importance in the community', that
'[lender of last resort] loans to individual
banks are neither necessary nor cost effec-
tive',
and that 'the potential for all bank
panics is reduced to almost zero when cen-
tral banks act intelligently'. The Benston—
Kaufman view draws on Kaufman's analy-
sis of the evidence on bank contagion.6
According to his study 'bank runs appear
to be bank-specific and rational', 'the fail-
ure rate for banks [1870-92] has on average
not been greatly different from that for
non-banks' and 'there is no evidence to
support the widely held belief that, even in
the absence of deposit insurance, bank con-
tagion is a holocaust that can bring down
solvent banks'. The Benston—Kaufman
approach suggests that in the absence of
federal deposit insurance prudential regula-
tion of banks is unnecessary and that the
need for regulation arises only from the
moral hazard generated by such insurance.
The more general view, at least among
policymakers, is that banking is inherently
fragile. This alleged fragility is based on
banks'
maturity transformation services,
the fact that banks' main asset class (com-
mercial loans) is worth less in liquidation
than on a going-concern basis and the opa-
city of banks' loan portfolios. Given these
bank characteristics, depositors have a
(rational) propensity to run at the first sign
of trouble. Furthermore, if the liquidation
value of a bank's assets is worth less than
the value of its liquid deposits a deposit
risk run can be quickly transformed into a
solvency crisis — thereby providing a
rational basis for runs even against healthy
banks.
Within such a framework individual
banks are vulnerable to sudden collapse and
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