FDIC & Moral Hazard

On a recent episode of the EconTalk podcast, Columbia professor Charles Calomiris argues that deposit insurance is at least part of the source of financial crises. He argues that deposit insurance frees banks from competing along dimension of risk.

His take is arresting, interesting, and worth consideration. He also discusses how the rich are able to essentially receive unlimited deposit insurance through certain sophisticated financial arrangements.

Megan McArdle, for one, is not convinced:

The sticking point for me is twofold. The first is that we had crises before there was moral hazard--really, really dreadful crises, crises far worse than the one we're having now. I just don't see how you can look at the 1930s and name the FDIC as the decade's biggest financial problem. Or this decade's biggest financial problem. The closest our era came to a really devastating financial crash along the lines of the 1929-1933 period was in the total unguaranteed institutional money market funds.

Nor do I find the central story of how the FDIC induced this moral hazard very compelling. Supposedly, ordinary depositors don't bother to check the soundness of their banks because they don't actually have skin in the game.

Anyone making this argument cannot have met many ordinary depositors. If you stripped away my mother's FDIC protection, she wouldn't do any better of a job at evaluating Citigroup's finances.

While I was initially taken with Calomiris' claim, I'm back in the unconvinced camp. In fact, I'm not sure deposit insurance is for the benefit of depositors at all. It seems to me what deposit insurance really does is free banks from the threat of a run and subsidizes borrowing.

When banks make loans they have to get the money from somewhere. They 'borrow' it from depositors, bundle it together, and make loans. The need to repay depositors on demand can obviously be a problem when you are in the business of loaning out most of the money you take in as deposits.

The assurance of a government guarantee on deposits decreases the likelihood that most or all of the depositors will show up on any given day demanding their money back. If this was a real danger, banks would have to offer higher interest rates to attract and retain deposits. This, in turn, would lead to higher interest rates on the money they lend out. In essence, deposit insurance is subsidizing borrowing, not depositing.

In order to be profitable banks still have to compete along the dimension of risk in that they have to make loans that ultimately perform. Deposit insurance though, allows banks the flexibility of managing their portfolio of loans without having to worry about mobs of depositors at their door demanding their money. A phenomenon that history has shown can destroy a bank and cripple an economy.