Deposit Insurance and Moral Hazard
Over the weekend, I listened to Russ Roberts’ EconTalk interview with Charles Calomiris. There’s far too much in this interview to unpack in a single post, so for now I only want to address Calomiris’ take on deposit insurance. He’s against it, and pins deposit insurance and other risk subsidies as the primary cause of many recent financial crises. I’m for it.
Calomiris’ broad claim is that government policies distort individual incentives to assess risk, and that these perverse incentives cause financial crises. He looks at past financial crises—which he defines as domestic banking losses exceeding 10% of GDP—and finds that while there were only four such crises globally from 1874 to 1913, there were 140 of them from 1978 to the present. So what happened? According to Calomiris, what caused the frequency of crises to spike was that governments began implementing policies to guarantee (or otherwise subsidize) certain types of risk-taking. His thinking is the familiar cry of moral hazard: when governments bail-out banks and their depositors, individuals are more willing to take risks knowing they’ll be able to share losses with their fellow taxpayers. The risks then build up in the banking sector and cause financial crises.
So which government policies are to blame, specifically? “Most important” of these government policies, says Calomiris, is deposit insurance. Deposit insurance, he argues, distorts depositors’ incentives to keep tabs on bank risk; and these perverse incentives are a necessary, if not sufficient, condition for financial crises.
Sandrew here. I grant that it’s not crazy to cry moral hazard in the face of deposit insurance, but I’m not yet convinced it has much of an effect. For one, the frequentist evidence feels a bit light. But more damning is that it’s hard for me to imagine a significant population of depositors who are capable of assessing bank tail risks, even if so incented. Lose your savings in a bank failure? Tough cookies, Ethel, you knew the risks. What, can’t you read a balance sheet? On this issue, it’s fair to call me a paternalist.
Calomiris dismisses the view that risk-bearing depositors mightn’t be so great at assessing risk. But interestingly, he later double-backs on himself when it comes to bank ownership. Here he is on fragmented ownership:
We’ve designed these [banking] institutions, by regulation, to be relatively immune to corporate governance—there isn’t sufficient number of stockholders with large, concentrated shares that can really discipline management…. What we need is concentrated ownership… particularly [by] sophisticated institutional investors.
It’s important to recognize here that fragmented owners are still owners. They have exactly the same economic incentives, in aggregate, as concentrated owners—the incentives are simply dispersed. And fragmented owners still have the voting rights to kick-out management. What Calomiris is pointing out is that small, unsophisticated investors either don’t know or don’t care enough to act in their own self-interest with respect to corporate governance. And yet he puts endless faith in Ethel the Depositor to discipline bankers with respect to murky and difficult-to-comprehend tail risks. Strange.
Deposit insurance makes sense to me. The majority of depositors lack the wherewithal and/or information required to make informed decisions about the riskiness of their deposits. So they pool their resources (taxes) and hire the FDIC to look after it on their behalf. Since they wouldn’t be very good disciplinarians in the status quo ante, the moral hazard cost of this insurance strikes me as negligible. A small price to pay for an end to depositor-driven bank runs, if you ask me.
