Deposit Insurance and Moral Hazard

Even great economists seem confused.

I am hoping to get back down to a cadence of one post a day, starting tomorrow. Also, I think that the discussion that Zach Weissmuller conducted with me and Lyn Alden proved interesting. She brought up several points I had not considered. I think that she is right to note similarities between the current environment and the post-WWII period.

Greg Mankiw writes,

I am not particularly concerned about the moral hazard associated with insuring all bank deposits (though the expansion of deposit insurance should be done explicitly, rather than through the implicit and ad hoc process now occurring). It is not realistic to expect bank depositors to monitor the health of their banks.

Charles Calomiris (WSJ) takes the opposite stance as Greg.

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. The popularity of deposit insurance reflects public ignorance about its costs and about how a disciplined, uninsured banking system could operate as an alternative.

Informed depositors respond to troubles at banks early, with withdrawals that pressure banks to reduce their riskiness. 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 [before we had deposit insurance], depositors’ losses on failed banks were small.

In terms of the academic credentials on his CV, I estimate that Greg is in the 99.9th percentile of Ph.D economists. Charlie is “only” in the 99th. I might be in the 50th if you’re being generous.

I think that both of them are off base.

On the question of whether bank depositors are in a decent position to monitor and deal with the risks that banks take, I disagree with Charlie. To make uninsured deposits safe for the depositor would require a complete redesign of banking. You could put deposit-taking banks into a regulatory straitjacket, which is John Cochrane’s solution. Or you could let banks be opaque, creative, and complex as they are today. In that case, the only way I think that depositors can put money in banks is if there emerges an industry that depositors are willing to trust to rate bank safety. The rating services would have expertise in penetrating bank balance sheets, and they would tell civilians where it is ok to put money . But would that rating industry reliably do its job, or would it screw up royally, as when rating agencies of mortgage securities played a pivotal role in the financial crisis of 2008?

On the other hand, Greg is full of, er, unwisdom, when he says that deposit insurance is not a moral hazard issue. It’s not the moral hazard of depositors that matters here. It is the moral hazard of bank owners and managers. They are the ones whose incentives are distorted by the ability to lure funds using a government guarantee.

I think that too many people, economists included, start by talking about moral hazard but end up thinking in terms of cosmic justice.

If you take the cosmic justice framing, you end up saying idiotic things, like “the shareholders of SVB lost everything, and executives got fired, so there is no moral hazard issue.” At best, what happened to the shareholders and executives satisfies cosmic justice. But it does nothing to eliminate moral hazard.

Or suppose you complain that the venture-funded businesses should not have gotten all their deposits back. From a cosmic justice perspective, I think they deserve to lose a little bit, maybe 2 or 3 percent of their money. If I understand correctly (and there is a high probability that I don’t), the founders received perks that made their deposits worth more than deposits at other banks, at least if they kept all their money with SVB. But I don’t think of that as a moral hazard issue, or at least not primarily.

The moral hazard in banking is that owners and managers are taking risks that are insured explicitly by the FDIC and implicitly by the government’s aversion to letting a bank fail. Unless shareholders and managers are satisfied with just a modest level of returns, they will look for ways to grow their deposit base and take on a risky asset mix. Heads, they win. Tails, the taxpayers lose. That is moral hazard.

This puts the onus on government regulators to limit banks’ risk-taking. And the regulators have never, ever, been successful at this. You would think that they would notice that a bank’s fast growth is a red-light warning sign, but no. You would think that they would rely on market value accounting measures, and put the bank in a straitjacket as soon as its equity falls below a certain level, but no.

The bank regulators have their own distorted incentives. If you think that “public service” is the same as public interest, I’ve got a Signature Bank board member named Barney Frank to show you. If you think that government’s main concern with banks is consumer welfare, I’ve got a book called The Cash Nexus to show you. It’s a tough slog to get through that book. Try my review instead.

If even Greg 99.9th percentile Mankiw does not have my understanding of the moral hazard issue, then that is discouraging to me. On the other hand, Matt Levine, who is in the 99.9th percentile of financial journalists, nails it.

The regulators’ response to SVB — guaranteeing all depositors, but also the Fed’s Bank Term Funding Program to finance other banks’ bond portfolios at par[7] — increases the value of other banks’ optionality, which encourages them to take more risk, because their deposits are safer. (I suppose this is the real moral hazard concern.) And so there should be more regulatory and supervisory changes to tamp down the other banks’ risks.

Until he doesn’t. Scott Sumner, who shares my frustration with what we see as wrong-headed takes on moral hazard, finds a different line from Levine that seems to get it wrong.