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.)

Continue reading →