Economist Writing Every Day

As you may have heard, there have been a few bank failures in the US in the past week. This has led ordinary people to start refreshing their memory about exactly what “deposit insurance” is and what it means for them. It has also led regulators, politicians, and economists to start refreshing their memory about the social purpose of deposit insurance, which is to stabilize the banking system. There are lots of aspects of the bank failures and deposit insurance to consider, but I think we can all agree that when ordinary people are thinking about this topic, bad things are going on.

While I can’t find a systematic survey of economists on this topic, my guess is that most economists would agree with the statement “on balance, deposit insurance promotes stability in the financial system.”

But there is a minority view, and one with (in my opinion) considerable historical support. Deposit insurance could potentially be destabilizing, since it has the potential (like any form of insurance) to create moral hazard. By lowering the cost of making mistakes, we would expect more mistakes. The cost need not be lowered all the way to zero for moral hazard to be a problem (bank owners still have some skin in the game), but the cost is certainly lower. These problems may be even more of a threat to the financial system than other areas of life covered by insurance.

That’s the theory. What’s the evidence?

My favorite paper on this topic is a 1990 article by Charles Calomiris called “Is Deposit Insurance Necessary? A Historical Perspective.” Not only does it conclude that deposit insurance isn’t necessary, but even more: it may be destabilizing. (You can also read a version of the article intended for a more general audience that Calomiris wrote for the Chicago Fed.)

Calomiris looks at state deposit insurance systems in US states in several time periods before the establishment of federal deposit insurance in the 1930s (specifically, the antebellum era and the 1920s). And there were many attempts! Here’s the short version: almost all of these deposit insurance systems failed. And moreover, we have plausible counterfactuals in each era, states with different regulatory and mutual insurance systems other than deposit insurance, which did not produce nearly the same number of failures and instability as states with deposit insurance. For a review of more articles that look at other time periods and countries, see this article by Hogan and Johnson.

While Calomiris is interested in systems from many decades ago, the publication of his article in 1990 was not random. Indeed, he starts out the article by providing the context for Why Should We Care About This History: “Following the current savings and loan collapse…” When I have my students read this article, they often breeze past that first clause. What collapse? But if you were an adult with a bank account in the late 1980s, you probably were also thinking about deposit insurance. The collapse of the FSLIC system (the parallel to FDIC for savings and loan institutions) meant many average people were thinking about deposit insurance. For example see these editorial cartoons by Etta Hulme from that era.

But while it’s Bad News when ordinary people have to think about deposit insurance, it could be Good News for reforming the system of deposit insurance. Interest both by researchers and policymakers ramps us during a crisis. But a crisis can also produce reforms that may destabilize the system down the road. Let’s hope the conversation moving forward is how to produce a more stable banking system, rather than whether specific individuals or firms need to be “bailed out” (which does create de facto expectations about future actions, but how the rules are rewritten is just as important).