The Effect of Deposit Insurance on the Good Bank and the Bad Bank

Deposit insurance, it is argued, is needed to cope with inherent fragility of banking and money market. To avoid panics, or financial crisis, a safety net on the system is required. Of course, such safety, is not free. There are not only direct economic costs, there are also indirect economic costs associated with the problem of moral hazard that such institutions bring to the market.

The problem of moral hazard consists in the incentives that make banks take more risk than they should. If a bank knows that free or cheap help will come on his way when facing financial distress, then the bank will invest in more risky projects than it should. The bank can get higher returns but the losses are cut short. The extent of the effect of the moral hazard is unobservable. We don’t know how much extra risk is taken by the banks due only to the effect of moral hazard. But a comparative analysis with and without the presence of deposit insurance helps us to understand how banks will react, even if we cannot precisely measure the extent of its effect.

As Kevin Dowd calls them in his “Moral Hazard and the Financial Crisis” (2009), we can assume two banks, the Good Bank and the Bad Bank. The Good Bank carefully invests in assets with due attention to not taking more risk than their customers want. The Bad Bank, on the other hand, invests in assets that were too risky. What will happen in the cases of (1) laissez-faire banking and (2) with a mandatory deposit insurance?

If we assume that the individuals are willing to have their savings in a bank account, then when Bad Bank is facing trouble, those who can get back their deposits will transfer their funds to Good Bank. The same will occur with those clients that find out that Bad Bank is investing too risky, and the loose of clients will put even more pressure on Bad Bank’s situation. As long as we keep our initial assumption that individuals want to keep their saving in a bank account, then the financial problem is localized and does not spread to the rest of the system. The structure of the banking market changes, but there is no reason to conclude system-wide bank runs without implicitly changing the assumption that individuals want to keep their money in a bank account. A change in this assumption would not explain a system-wide bank run, it will assume it. Because banks are not going to be bailed out if they get into trouble, each bank has strong incentives to communicate about the soundness of their situation to (1) avoid loosing customers and (2) attracting new customers from Bad Bank.Even though it is possible for things to go wrong anyway (i.e. banks failing to communicate), the incentives in place protect the stability of the system as a whole.

But if there’s a deposit insurance, specially if sponsored by the government, then the incentives in place change and so does the behavior of the market participants. In the previous case, Good Bank has good reasons to behave prudently rather than recklessly even if it cannot offer to his clients rates of return as good as Bad Bank. Good Bank is waiting for clients of Bad Bank to realized that the portfolio invested by the bank is more risky than what they are willing to accept and transfer there account to Good Bank. With the deposit insurance the benefit of this strategy goes away. If Bad Bank is going to be saved, then his clients don’t need to transfer their accounts go Good Bank, and there is no need for Good Bank to invest prudently. If Good Bank want to stay in the market, then it will have to increase the risk of his portfolio because there are no more reasons for their clients to accept a lower rate of return if they are not going to pay when the risk materializes.

Thus, the problem is not only that Bad Bank stays in the market, but also that Good Bank faces strong incentives to behave as Bad Bank. The whole system becomes biased to be over risky.

Does this mean that the banks should not be allowed to have a deposit insurance? No, it means that risk management should be the result of a free exchange in the market and not a government sponsored or a mandatory rule. If any bank wants to insurance their deposits, then they should bare the corresponding cost. What is happening is that the bank is selling out the risk to the insurance company for a given price. If , for example, Bad Bank hires insurance at a fair price for the risk differential with Good Bank’s portfolio, then the interest rate that he’ll be able to offer to his clients will be the same than the interest rate offered by Good Bank. Both banks are now facing the same riskiness in their portfolios. It is now the insurance company the one who will have to deal with the associated risk that has bought.

The question is not whether there should be or not risk, but who bares the risk. If it’s left to the market, then the companies specialized in managing risk will be willing to buy the risk and benefit in the exchange. This is what insurance companies do. But, if deposit insurance is sponsored by the government, for example through a subsidy or a lender of last resort, then the cost of the risk is shifted to the individuals. A case of concentrated benefits (money market) and distributed cost (society). If the government subsidizes the insurance, then it has to collect taxes, which means that the tax payers are unwillingly paying the subsidized part of the insurance. If the insurance comes in the form of a lender of last resort (that lends cheaply to the banks), then the central bank can print new money or buy money from the market by selling new bonds when the hard times come. In either case, the cost is transferred to society. In the former in the form of higher prices (loss of purchasing power) and in the latter through higher government debt.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

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