Deposit Insurance and Moral Hazard: Lessons from the Cyprus Crisis
In a new policy note, Jan Kregel draws out some of the policy lessons of the Cypriot deposit tax episode for plans to create a system of EU-wide deposit insurance. In addition to the necessity of a strong central bank (the ECB in this case) standing behind the deposit insurance scheme (which does not appear to be part of the current plans), Jan Kregel explains why a certain amount of moral hazard is inescapable.
We can see this by looking at two types of deposits that correspond to the dual functions of banks: deposits of currency and coin, and deposits created when loans are made. If a bank makes bad loans — and as Kregel points out, “it is the failure of the holder of the second type of deposit [loan-created deposits] to redeem its liability that is the major cause of bank failure” — the first type of depositor (of currency and coin) should not bear the brunt of these bad decisions. The role of deposit insurance, one might argue, is to provide such protection.
But since deposit insurance has to be extended to all of a banks’ deposits (up to a certain level), including those created by loans, moral hazard is inevitable. Ideally, deposit insurance would be structured in such a way as to distinguish between deposits based on currency and coin and deposits generated through loans, as well as between deposits created by good and bad loans (loans that default). But if you examine how the banking system functions, says Kregel, this isn’t operationally possible:
Unfortunately, it is impossible in practice to make these distinctions between reserve deposits, defaulted-loan-created deposits, and deposits created by loans that are current. It is for this reason that there are limits on the size of insured deposits based on the presumption that the first type of deposits will be relatively small household deposits created by the transfer of reserves and used as means of payment or store of value. It thus limits coverage of the other types of deposits. However, this is clearly inequitable for the deposits held by borrowers who are still current on their loans.
As he explains, with some help from Minsky, it is the means of payment function that makes these distinctions practically impossible (for more on why this is, read the note here). Kregel concludes that “It would thus seem impossible to design a truly fair deposit insurance scheme that eliminates the inherent moral hazard and the necessity of a contingent guarantee of the central bank.”
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Kregel suggests that those who deposit “currency and coin” at a bank should not “bear the brunt” of bad lending decisions by banks. While in contrast, those who deposit commercial bank created money SHOULD take a hair cut.
This is very close to a suggestion made by various advocates of full reserve banking, as follows. Depositors should have to make a choice between two options. One is to have their money (or some of it) lodged in a 100% safe manner (e.g. lodged at the central bank). The state guarantees that money, but nothing is done with the money: it is not loaned on or invested, thus it is exposed to virtually no risk. Thus there is virtually no taxpayer exposure there.
The second option is for depositors to let their bank lend on or invest their money. In that case the money earns interest, which benefits the depositor. But also the depositor foots the entire bill for any bad loans/investments. In effect, the depositor no longer has a specific sum of money in the bank: the depositor has a stake which can rise or fall in value.
Advocates of the latter system include Laurence Kotlikoff and this lot:
http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf
Amongst the advantages of that system are first, the fact that it is impossible for a bank to SUDDENLY fail. That is the latter stake held by depositors can drift downwards in value, but sudden failure is impossible. Second, there is no taxpayer funded subsidy of banks (TBTF or otherwise). Third, the above system solves a problem which seems to perplex Kregel: that’s his claim that it is impossible to distinguish between the two types of account he refers to, and with a view to having government guarantee one, but not the other.
Incidentally, while the latter system is part and parcel of full reserve banking, as far as I can see, the latter “two types of account” system COULD BE tacked onto a fractional reserve system. I.e. the adopting the two account system does not mean one has to accept full reserve, lock stock and barrel.
That all gives rise to an obvious question, namely whether the two types of deposits at banks proposed by Kregel makes sense, or whether the two types of deposit account proposed by full reservers is better. I suggest that Kregel’s distinction between currency deposits and other deposits does not in fact make sense, and for the following reasons.
If someone deposits currency or coin (or more generally monetary base) with the intention of letting their bank lend on or invest the money, than the depositor no longer has any currency or coin in the bank. (That’s in contrast to where someone deposits a bundle of $100 bills in a safe deposit box at a bank. In that case the bills are still there: they are not loaned on or invested. That is sometimes called “warehouse banking”, and that form of deposit amounts to the same thing as the safe accounts proposed by full reservers.)
I.e. where someone deposits currency with a view to letting the bank lend on the money, the depositor is in effect making an investment (or loan) with the bank simply acting as intermediary. In that case, the depositor / investor has no right to government support if it all goes belly up: any more than if I were to make a stock exchange investment paid for by giving my stockbroker a bundle of $100 bills.