Government Deposit Insurance: A Dumb Idea

Lawrence W. Reed

A headline on an Associated Press story in mid-June read, “Doubling Deposit Insurance Opposed.” Surprisingly, the Clinton administration–which can usually be counted on to support anything that extends the reach of government–had come out against a proposal to raise the amount of bank deposits insured by the Federal Deposit Insurance Corporation from $100,000 to $200,000. Apparently, broken clocks aren’t the only thing that are right twice a day.

The hike was proposed not by savers, pensioners, or consumer groups but by groups representing banks, which was no surprise at all. Bailing out big banks and their depositors is a form of banker welfare in which the bankers get well and you and I pay the fare. Federal Reserve Chairman Alan Greenspan was right on the money when he said that the plan would give “increased subsidies to upper-income individuals”.

The banker-welfare advocates will surely not drop the issue any time soon, which just might give the nation an opportunity to reconsider the larger question: Should government be insuring bank deposits at all? Count my vote in the “no” column.

The federal government first got into the deposit insurance business in the 1930s, and ever since, the public has largely accepted the principle that for the sake of the general economy, banks shouldn’t be allowed to fail. But there’s a huge “moral hazard” problem with bank bailouts. If government sends the message that banks can’t fail and that it will act to prevent failures, it will actually produce the kind of bad behavior that defines a failing bank. After all, why behave in a sober fashion if the government will pay you to get drunk?

If government policy declares, “We won’t bail out the little ones, only the big ones whose failure would have massive ripple effects,” then you only create a bigger moral hazard because big banks can and will make big mistakes if they know they’ll be taken care of. That works against the ability of small banks to compete, which in time undermines the soundness of the banking system in general.

Two analysts at the Federal Reserve Bank of Minneapolis, Ron J. Feldman and Arthur J. Rolnick, have argued that the way the government protects banks and their depositors through its deposit insurance has indeed created major problems of its own:

While other explanations for the huge number of bank failures [in the 1980s] are plausible, we view too much protection as a critical underlying cause. Once its depositors and other creditors are fully protected, a bank is likely to take much more risk than it would otherwise. This is especially true at banks where owners can diversify their risk or at banks that are seriously undercapitalized. In effect, it’s heads the bank wins and tails the taxpayer loses.

We should not assume, by the way, that any failure by any bank is automatically something that must be artificially prevented or that would automatically cause disastrous ripple effects if it weren’t. The fact that a bank can fail (or any business, for that matter) tends to promote healthy practices that minimize the problem. And when a bank does fail, it does not mean that all of its depositors’ money disappears. A failed bank in a free market can be bought out by another bank, or otherwise emerge from an orderly bankruptcy process stronger than before, though its investors and depositors may lose some of their money.

Federal deposit insurance was intended, in part, to ward off widespread bank runs that are symptomatic of financial panic. It has indeed accomplished that, but not without the law of unintended consequences operating in the opposite direction. As economist George G. Kaufmann put it in a recent issue of the Cato Journal, “The absence of runs removed a major automatic mechanism by which troubled banks were previously closed and resolved. Runs on troubled banks caused liquidity problems, which forced regulators to suspend their operations until their solvency could be determined. In this way, depositors prevented insolvent institutions from remaining in operation for long and thereby limited the ability of these banks to enlarge their losses.”

The savings and loan crisis of the 1980s is a perfect example of the massive harm government insurance can cause. In 1980, under the Carter administration, the Congress passed a deregulatory act that gave S & Ls greater freedom to invest in a variety of instruments. So far so good. That part was needed so that S & Ls could compete. But at the same time, government raised the amount of deposits that it would insure from $40,000 to $100,000. Moreover, the Federal Savings and Loan Insurance Corporation’s flat-rate premiums were retained.

In other words, S & Ls that used their new freedom to invest in shaky or even unconscionable things would continue to pay no more in insurance premiums than the S & Ls that invested prudently! (Can you imagine the signal it would send if auto insurance companies charged the same premiums to careful and drunk drivers?)

What Congress should have done was to privatize deposit insurance. No private insurer would ever charge banks or S & Ls with bad lending practices the same low premiums it charged those with sound practices. Only bureaucratic planners working in government do such idiotic things, and then in infantile fashion, blame the free market for the results.

Sadly, those who think government must provide deposit insurance fail to realize how much of the problem they see is already the result of government’s own handiwork. If banks fail, the free market is blamed and government is called on to intervene.

It is superficial and wrong to conclude that bank failures require government bailouts. The best thing government can do if it wants to avoid such disasters is to foster the soundest possible environment for good business and banking practices: Don’t erode the currency through deficit spending and credit expansion, don’t adopt ludicrous deposit insurance practices, don’t reward banks for unsound lending practices.

This isn’t pie-in-the-sky theory. We should now know from actual practice that government monetary and fiscal policies have created far more bank failure problems than an unfettered free market could ever conceivably create if it wanted to. Like any other risky activity, banking should secure its insurance from watchful, responsible private entities rather than from politicians and the bureaucrats they employ.

Federal deposit insurance should not be doubled. It ought instead to be privatized!

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