The president of a central Minnesota bank
and former director of this bank, Pete Allen, recently dropped me
a note about reforming federal deposit insurance. When he heard
that I was going to be speaking on this issue at a recent Minnesota
Bankers Association management conference, Pete wanted to offer
some friendly advice on a topic that has become popular in light
of the costly savings and loan bailout. He was concerned that "John
Q. Public" had no way of knowing whether a bank was safe, and Pete
urged me not to support an approach to reform that, in effect, relied
on the public to regulate banks. Pete is not the only one with this
concern; in fact he is in very distinguished company. L. William
Seidman, chairman of the Federal Deposit Insurance Corporation,
commenting on whether depositors can be relied on to discipline
banks, has stated, "We have a hard enough time figuring out a bank's
financial condition. I don't see how you can expect a depositor
to do it."
The concern of both gentlemen, while understandable, is unnecessary.
Regardless of the lack of sophistication of the average depositor
or even most depositors, market discipline will work for bank deposits
just as it does in other markets for financial assets where the
average investor is no more sophisticated than the average depositor.
Both Pete Allen and Bill Seidman are responding to the type of
proposal that appeared in the Minneapolis Fed's 1988 Annual Report.
In that essay John Boyd, senior research officer, and I recommended
that bank deposits be coinsured, so that depositors share some of
the risk of a bank failure. Under the current system, all deposits
at large banks are virtually 100 percent guaranteed, while deposits
at other banks are insured up to $100,000 per account. We instead
advocate a 100 percent guarantee for deposits up to $10,000, only
one fully insured account per person and 90 percent coverage (coinsurance)
for everything over $10,000. Consequently, anyone with more than
$10,000 in deposits would be subject to some risk of loss if their
bank should fail. We also recommended that any such proposal be
The rationale behind coinsurance is to bring some market discipline
to bear on depository institutions' behavior toward risk. Most insurance
has a potentially costly side effect. It encourages the insured
to take on more risk than they would otherwise (this is the so-called
moral hazard problem) and deposit insurance is no exception. But
with coinsurance, risk-averse depositors will either require banks
to hold safe portfolios or pay a risk- adjusted rate of interest.
In either case depository institutions will have less incentive
to take on excessive risk.
Pete Allen and Bill Seidman are worried that the market will not
work as we suggest because most depositors are not sophisticated
about banking and know little about their bank's portfolio. While
they may be correct about the sophistication and knowledge of most
depositors, they are wrong in concluding that this will somehow
prevent the market from properly pricing bank risk and reducing
the incentives insured institutions have toward risk.
Depositors' ability or willingness to monitor banks should not
be judged by their current behavior. Given that bank deposits today
are almost fully insured, it is not surprising that few depositors
know or care about their banks' portfolios. But imagine a world
with no deposit insurance. Potential depositors would surely demand
information about the safety of a bank's portfolio. Those banks
holding safe portfolios would in turn want the public to know about
their investment strategy because the safer the bank the lower the
rates they have to pay depositors; they will have an incentive to
advertise their high safety standards. Those banks pursuing more
risky portfolios may try to provide little information about their
portfolio. This strategy, though, could backfire as risk-averse
depositors and competition could easily drive their deposit rates
much higher than if they fully informed the public. Risky banks
may also try to misinform the public, but government regulators
and independent rating agencies will serve to minimize this behavior.
That the public can evaluate and price risk is obvious in many
markets. The market for mutual funds is a good example, where returns
on these funds reflect the riskiness of their portfolios. Others
include the markets for stocks, bonds, houses and cars. And there
is no reason to believe we would see anything different in the market
for coinsured deposits.
Indeed, before federal deposit insurance was established in 1933,
the public did monitor banks. A good example occurred in the mid-19th
century, during the so-called free banking era, when local newspapers
and specialized bank periodicals regularly reported on bank conditions.
Given the demand for this information, the local media found it
profitable to, in effect, provide a bank rating service.
A recent study of banking in the 1920s is also revealing about
the public's ability to assess bank risk. This study found that
banks with the riskier portfolios paid higher rates of interest
on their deposits, while banks that had the safer portfolios (for
example, more liquid) paid much lower rates. Somehow, at least some
depositors knew how to distinguish between safe and risky banks.
And other depositors, the presumably unsophisticated, could distinguish
between safe and risky banks by the rates on deposits they offered.
An MBA degree is not required to understand that banks paying higher
rates must be investing in higher risk assets.
All of this, of course, is not to imply deposit insurance should
be eliminated. I am well aware of the history of banking crises
before bank deposits were insured by a federal agency. The Minneapolis
Fed's proposal doesn't come close to eliminating deposit insurance;
it is a modest attempt to bring some market discipline back into
I am sure that Pete Allen will not be surprised to learn that
I did not take his advice. He knows that I generally prefer a market
solution to most economic problems. Nevertheless, he raises an often-heard
concern that those of us who advocate a market discipline approach
to deposit insurance reform should address.