Financial Markets and Institutions (2-downloads)

The Spread of Government Deposit Insurance

Throughout the World: Is This a Good Thing?

For the first 30 years after federal deposit insurance

was established in the United States, only six coun-

tries emulated the United States and adopted deposit

insurance. However, this began to change in the late

1960s, with the trend accelerating in the 1990s,

when the number of countries adopting deposit insur-

ance topped 70. Government deposit insurance has

taken off throughout the world because of growing

concern about the health of banking systems, particu-

larly after the increasing number of banking crises in

recent years (documented at the end of this chapter).

Has this spread of deposit insurance been a good

thing? Has it helped improve the performance of the

financial system and prevent banking crises?

The answer seems to be 

no under many circum-

stances. Research at the World Bank has found that,

on average, the adoption of explicit government

deposit insurance is associated with less banking sec-

tor stability and a higher incidence of banking

crises.* Furthermore, on average, it seems to retard

financial development. However, the negative effects

of deposit insurance appear only in countries with

weak institutional environments: an absence of rule of

law, ineffective regulation and supervision of the

financial sector, and high corruption. This is exactly

what might be expected because, as we will see later

in this chapter, a strong institutional environment is

needed to limit the moral hazard incentives for banks

to engage in the excessively risky behavior encour-

aged by deposit insurance. The problem is that devel-

oping a strong institutional environment may be very

difficult to achieve in many emerging market coun-

tries. This leaves us with the following conclusion:

Adoption of deposit insurance may be exactly the

wrong medicine for promoting stability and efficiency

of banking systems in emerging market countries.

*See World Bank, 

Finance for Growth: Policy Choices in a Volatile

World (Oxford: World Bank and Oxford University Press, 2001).

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crisis (discussed in Chapter 10). This form of support is often referred to as the

“lender of last resort” role of the central bank. In other cases, funds are provided

directly to troubled institutions, as was done by the U.S. Treasury and by other gov-

ernments in 2008 during a particularly virulent phase of the 2007–2009 financial

crisis. Governments can also take over (nationalize) troubled institutions and guar-

antee that all creditors will be repaid their loans in full.

Moral Hazard and the Government Safety Net

Although a government safety

net can help protect depositors and other creditors and prevent, or ameliorate, finan-

cial crises, it is a mixed blessing. The most serious drawback of the government safety

net stems from moral hazard, the incentives of one party to a transaction to engage

in activities detrimental to the other party. Moral hazard is an important concern in

insurance arrangements in general because the existence of insurance provides

increased incentives for taking risks that might result in an insurance payoff. For

example, some drivers with automobile collision insurance that has a low deductible

might be more likely to drive recklessly, because if they get into an accident, the insur-

ance company pays most of the costs for damage and repairs.

Moral hazard is a prominent concern in government arrangements to provide a

safety net. With a safety net, depositors and creditors know that they will not suffer

losses if a financial institution fails, so they do not impose the discipline of the mar-

ketplace on these institutions by withdrawing funds when they suspect that the finan-

cial institution is taking on too much risk. Consequently, financial institutions with a

government safety net have an incentive to take on greater risks than they otherwise

would, with taxpayers paying the bill if the bank subsequently goes belly up. Financial

institutions have been given the following bet: “Heads I win, tails the taxpayer loses.”

Adverse Selection and the Government Safety Net

A further problem with a

government safety net, like deposit insurance arises because of adverse selection, the

fact that the people who are most likely to produce the adverse outcome insured

against (bank failure) are those who most want to take advantage of the insurance.

For example, bad drivers are more likely than good drivers to take out automobile

collision insurance with a low deductible. Because depositors and creditors protected

by a government safety net have little reason to impose discipline on financial insti-

tutions, risk-loving entrepreneurs might find the financial industry a particularly

attractive one to enter—they know that they will be able to engage in highly risky

activities. Even worse, because protected depositors and creditors have so little

reason to monitor the financial institution’s activities, without government inter-

vention outright crooks might also find finance an attractive industry for their activ-

ities because it is easy for them to get away with fraud and embezzlement.

“Too Big to Fail”

The moral hazard created by a government safety net and the

desire to prevent financial institution failures have presented financial regulators with

a particular quandary. Because the failure of a very large financial institution makes

it more likely that a major financial disruption will occur, financial regulators are

naturally reluctant to allow a big institution to fail and cause losses to its deposi-

tors and creditors. Indeed, consider Continental Illinois, one of the 10 largest banks

in the United States when it became insolvent in May 1984. Not only did the FDIC

guarantee depositors up to the $250,000 insurance limit, but it also guaranteed

accounts exceeding $250,000 and even prevented losses for Continental Illinois bond-

holders. Shortly thereafter, the Comptroller of the Currency (the regulator of national

banks) testified to Congress that 11 of the largest banks would receive a similar treat-

ment to that of Continental Illinois. Although the comptroller did not use the term

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“too big to fail” (it was actually used by Congressman Stewart McKinney in those

hearings), this term is now applied to a policy in which the government provides guar-

antees of repayment of large uninsured creditors of the largest banks, so that no

depositor or creditor suffers a loss, even when they are not automatically entitled

to this guarantee. The FDIC would do this by using the purchase-and-assumption

method, giving the insolvent bank a large infusion of capital and then finding a will-

ing merger partner to take over the bank and its deposits. The too-big-to-fail policy

was extended to big banks that were not even among the 11 largest. (Note that “too

big to fail” is somewhat misleading because when a financial institution is closed or

merged into another financial institution, the managers are usually fired and the

stockholders in the financial institution lose their investment.)

One problem with the too-big-to-fail policy is that it increases the moral hazard

incentives for big banks. If the FDIC were willing to close a bank using the payoff

method, paying depositors only up to the $250,000 limit, large depositors with more

than $250,000 would suffer losses if the bank failed. Thus they would have an incen-

tive to monitor the bank by examining the bank’s activities closely and pulling their

money out if the bank was taking on too much risk. To prevent such a loss of deposits,

the bank would be more likely to engage in less risky activities. However, once large

depositors know that a bank is too big to fail, they have no incentive to monitor the

bank and pull out their deposits when it takes on too much risk: No matter what

the bank does, large depositors will not suffer any losses. The result of the too-big-

to-fail policy is that big banks might take on even greater risks, thereby making bank

failures more likely.

1

Similarly, the too-big-to-fail policy increases the moral hazard incentives for non-

bank financial institutions that are extended a government safety net. Knowing that

the financial institution will get bailed out, creditors have little incentive to monitor

the institution and pull their money out when the institution is taking on excessive

risk. As a result, large or interconnected financial institutions will be more likely to

engage in highly risky activities, making it more likely that a financial crisis will occur.

Financial Consolidation and the Government Safety Net

With financial inno-

vation and the passage of the Riegle-Neal Interstate Banking and Branching

Efficiency Act of 1994 and the Gramm-Leach-Bliley Financial Services Modernization

Act in 1999, financial consolidation has been proceeding at a rapid pace, leading

to both larger and more complex financial organizations. Financial consolidation

poses two challenges to financial regulation because of the existence of the gov-

ernment safety net. First, the increased size of financial institutions as a result of

financial consolidation increases the too-big-to-fail problem, because there will

now be more large institutions whose failure would expose the financial system to

systemic (systemwide) risk. Thus more financial institutions are likely to be treated

as too big to fail, and the increased moral hazard incentives for these large institu-

tions to take on greater risk can then increase the fragility of the financial system.

Second, financial consolidation of banks with other financial services firms means

that the government safety net may be extended to new activities such as securities

underwriting, insurance, or real estate activities, as has occurred during the recent

financial crisis in 2008. This increases incentives for greater risk taking in these activ-

ities that can also weaken the fabric of the financial system. Limiting the moral

1

Evidence reveals, as our analysis predicts, that large banks took on riskier loans than smaller banks

and that this led to higher loan losses for big banks; see John Boyd and Mark Gertler, “U.S. Commercial

Banking: Trends, Cycles and Policy,” NBER Macroeconomics Annual, 1993, pp. 319–368.

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hazard incentives for the larger, more complex financial organizations that have

arisen as a result of recent changes in legislation will be one of the key issues fac-

ing banking regulators in the aftermath of the 2007–2009 financial crisis.

Restrictions on Asset Holdings

As we have seen, the moral hazard associated with a government safety net encour-

ages too much risk taking on the part of financial institutions. Bank regulations that

restrict asset holdings are directed at minimizing this moral hazard, which can cost

the taxpayers dearly.

Even in the absence of a government safety net, financial institutions still have

the incentive to take on too much risk. Risky assets may provide the financial insti-

tution with higher earnings when they pay off, but if they do not pay off and the insti-

tution fails, depositors and creditors are left holding the bag. If depositors and

creditors were able to monitor the bank easily by acquiring information on its risk-

taking activities, they would immediately withdraw their funds if the institution was

taking on too much risk. To prevent such a loss of funds, the institution would be

more likely to reduce its risk-taking activities. Unfortunately, acquiring information

on an institution’s activities to learn how much risk it is taking can be a difficult

task. Hence most depositors and many creditors are incapable of imposing disci-

pline that might prevent financial institutions from engaging in risky activities. A

strong rationale for government regulation to reduce risk taking on the part of finan-

cial institutions therefore existed even before the establishment of government safety

nets like federal deposit insurance.

Because banks are most prone to panics, they are subjected to strict regula-

tions to restrict their holding of risky assets such as common stocks. Bank regulations

also promote diversification, which reduces risk by limiting the dollar amount of loans

in particular categories or to individual borrowers. With the extension of the gov-

ernment safety net during the 2007–2009 financial crisis, it is likely that nonbank

financial institutions may face greater restrictions on their holdings of risky assets.

There is a danger, however, that these restrictions may become so onerous that the

efficiency of the financial system will be impaired.

Capital Requirements

Government-imposed capital requirements are another way of minimizing moral haz-

ard at financial institutions. When a financial institution is forced to hold a large

amount of equity capital, the institution has more to lose if it fails and is thus more

likely to pursue less risky activities. In addition, as was illustrated in Chapter 17, cap-

ital functions as a cushion when bad shocks occur, making it less likely that the finan-

cial institution will fail, thereby directly adding to the safety and soundness of

financial institutions.

Capital requirements for banks and investment banks take two forms. The first

type is based on the leverage ratio, the amount of capital divided by the bank’s total

assets. To be classified as well capitalized, a bank’s leverage ratio must exceed 5%;

a lower leverage ratio, especially one below 3%, triggers increased regulatory restric-

tions on the bank. Through most of the 1980s, minimum bank capital in the United

States was set solely by specifying a minimum leverage ratio.

In the wake of the Continental Illinois and savings and loans bailouts, regula-

tors in the United States and the rest of the world became increasingly worried about

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Chapter 18 Financial Regulation