Saturday, September 22, 2007

Deposit Insurance: U.K. May Increase Coverage

by Calculated Risk on 9/22/2007 06:01:00 PM

From Bloomberg: U.K. May Insure 100,000 Pounds of Depositor Funds (hat tip FFDIC)

The U.K. government may guarantee as much as 100,000 pounds ($202,000) of people's bank deposits as it seeks to avoid a repeat of the run on Northern Rock Plc, Chancellor of the Exchequer Alistair Darling said.
Currently the official deposit insurance program covers 100% of the first £2,000, and 90% up to £35,000. This is a flawed insurance program, and didn't prevent the bank run at Northern Rock. To stop the bank run, the British government ended up guaranteeing all deposits - talk about encouraging moral hazard!

Although most people think deposit insurance is intended to protect depositors, perhaps a more important reason for insurance is to prevent bank runs and maintain the stability of the financial system.

The problem with the current British system isn't the size of the insured deposit £35,000 (about $70,000) but the coinsurance feature above £2,000. The coinsurance idea is flawed, both in concept and in practice (see Northern Rock). The idea of having relatively small depositors assess the risk of a bank is absurd. In practice, small depositors will just move their deposits to another bank at the slightest hint of trouble.

Many other coinsurance programs work very well. As an example, a co-pay for a doctor's visit lowers the overall cost of medical care. Without a co-pay, some patients overuse the services of doctors (this isn't a discussion of health care, rather an example of a positive aspect of coinsurance). But the purpose of coinsurance for deposit insurance is to encourage the depositor to assess the risk of the institution - something perhaps beyond the capability of most depositors. And even if the depositor has the skill to assess the institution, and the access to adequate information, it is still easier to just move their funds.

There are Moral Hazard and Principal/Agent issues with deposit insurance. For those interested in this topic, I suggest this paper, written in 1999 by George Hanc at the FDIC: Deposit Insurance Reform: State of the Debate. Here is an excerpt on Moral Hazard:
When applied to deposit insurance, the term moral hazard refers to the incentive for insured banks to engage in riskier behavior than would be feasible in the absence of insurance. Because insured depositors are fully protected, they have little incentive to monitor the risk behavior of banks or to demand interest rates that are in line with that behavior. Accordingly, banks are able to finance various projects at interest costs that are not commensurate with the risk of the projects, a situation that under certain circumstances may lead to excessive risk taking by banks, misallocation of economic resources, bank failures, and increased costs to the insurance fund, to solvent banks, and to taxpayers.

Moral hazard is present because (1) a stockholder's loss, in the event a bank fails, is limited to the amount of his or her investment; and (2) deposit insurance premiums have been unrelated to, or have not fully compensated the FDIC for, increases in the risk posed by a particular bank. Moral hazard is particularly acute for institutions that are insolvent or close to insolvency. Owners of insolvent or barely solvent banks have strong incentives to favor risky behavior because losses are passed on to the insurer, whereas profits accrue to the owners. Owners of nonbank companies with little capital also have reason to favor risky activities, but attempts to shift losses to creditors are restrained by demands for higher interest rates, refusal to roll over short-term debt, or, in the case of outstanding longterm bond indebtedness, restrictive covenants required when the bonds were issued.

Probably the most effective counterforce to moral hazard is a strong capital position. Because losses will be absorbed first by bank capital, the likelihood (other things being equal) that they will be shifted to the FDIC diminishes as the capital of the bank increases. In addition, increased capital serves to protect creditors and helps reduce distortions in bank funding costs caused by deposit insurance. Capital regulation, therefore, tends to curb moral hazard, as do other forms of supervisory intervention--specifically the examination, supervision, and enforcement process. Moreover, risk-based capital standards and risk-based insurance premiums attempt to impose costs on banks according to the institutions' risk characteristics.
In the U.S., the insurance premium is based on the FDIC's evaluation of the riskiness of the institution. The FDIC is in a much better position to judge the riskiness of institutions than depositors.

Placing the burden on the depositor defeats the purpose of deposit insurance:
Proposals for exposing depositors to greater risk seek to induce depositors to increase their monitoring of bank risk and, by means of their deposit and withdrawal activity, discipline and restrain risky banks. However, increasing depositors' risk could defeat the very purpose of deposit insurance.

...one should bear in mind the following considerations: (1) the relative cost of acquiring the information and analytical skills needed to monitor bank risk as compared with the cost and/or inconvenience of shifting funds to alternative investments entailing little risk; (2) the ability of depositors (and other market participants) to monitor bank risk effectively on the basis of publicly available data, given the 'opaque' quality of bank loan portfolios; and (3) the threat to the stability of the banking system resulting when potentially ill-informed depositors have greater risk exposure.
If the U.K. is going to offer deposit insurance, my suggestion would be to set the limit to cover the total deposits of say 98% of all depositors (£35,000 might be sufficient), and eliminate the coinsurance feature (insure 100% to £35,000).