Deposit Insurance: Theories and Facts

Charles W. Calomiris
Columbia University – Columbia Business School; National Bureau of Economic Research (NBER)

Matthew Jaremski
Colgate University; National Bureau of Economic Research (NBER)

April 2016

Columbia Business School Research Paper No. 16-35


Economic theories posit that bank liability insurance is designed as serving the public interest by mitigating systemic risk in the banking system through liquidity risk reduction. Political theories see liability insurance as serving the private interests of banks, bank borrowers, and depositors, potentially at the expense of the public interest. Empirical evidence – both historical and contemporary – supports the private-interest approach as liability insurance generally has been associated with increases, rather than decreases, in systemic risk. Exceptions to this rule are rare, and reflect design features that prevent moral hazard and adverse selection. Prudential regulation of insured banks has generally not been a very effective tool in limiting the systemic risk increases associated with liability insurance. This likely reflects purposeful failures in regulation; if liability insurance is motivated by private interests, then there would be little point to removing the subsidies it creates through strict regulation. That same logic explains why more effective policies for addressing systemic risk are not employed in place of liability insurance. The politics of liability insurance also should not be construed narrowly to encompass only the vested interests of bankers. Indeed, in many countries, it has been installed as a pass-through subsidy targeted to particular classes of bank borrowers.

Deposit Insurance: Theories And Facts – Introduction

The insurance of bank liabilities began as an American experiment in six U.S. states in the early-to-mid 19th century. All six of those state liability insurance experiments had disappeared by the 1860s. A second wave of eight U.S. state experiments with deposit insurance occurred in the early 20th century, and again, all of those had disappeared by around 1930.1 In 1933, after fifty years of failed attempts by advocates of deposit insurance to pass federal legislation and in the wake of the collapses of the eight state deposit insurance systems, U.S. federal deposit insurance was enacted. Although it was initially established as a temporary measure covering only small deposits, it soon became a permanent feature of the U.S. banking regulation that covers (either explicitly or implicitly) virtually all deposits today. Bank liability insurance remained an exceptional and controversial policy experience of the United States until the latter half of the 20th century. However, today it stands as a nearly ubiquitous feature of banking regulation that is endorsed by influential cross-border institutions such as the International Monetary Fund, the World Bank, and the European Union. As it spread to new nations, the extent of deposit insurance coverage within countries has also expanded.

This paper reviews the worldwide experience with bank liability insurance – including an analysis of the factors that led to its passage and expansion, as well as analyses of its performance, and connects the history of liability insurance to competing theoretical arguments that seek to explain it. Broadly speaking, there are two theoretical approaches to explaining the creation and expansion of deposit insurance: an economic approach grounded in potential efficiency gains (i.e., public interest motivation), and a political approach grounded in the rising power of special interest groups that favored it (i.e., private interest motivation).

The economic approach posits that liability insurance may improve the efficient management of the banking system by reducing systemic liquidity risk. Despite that potential advantage, economic theories recognize the costs of enacting liability insurance. These include moral-hazard and adverse-selection costs, which increase fundamental insolvency risk, either as a consequence of greater conscious risk taking by bankers (moral hazard) or through an increase in the proportion of bankers who are incompetent managers. Whether bank liability insurance, on balance, reduces or increases risk in the banking system is an empirical question.

Alternatively, political theory provides a separate theoretical basis for explaining the presence of bank liability insurance. Political models identify circumstances under which the interests of particular groups within society (beneficiaries of passing liability insurance) may succeed in securing its passage, even though liability insurance is inefficient. Political models seek to explain why liability insurance may occur to favor certain groups in society at the expense of other groups and at the cost of higher systemic risk of banks.

After reviewing the economic and political theories of liability insurance in Section II, Section III reviews empirical evidence about factors that have been instrumental in creating or expanding deposit insurance, and the economic consequences of doing so. We conclude Section III by considering what these two types of evidence tell us about which of the two theoretical paradigms reviewed in Section II – the economic theory or the political theory– is more consistent with the facts. We show that the empirical literature on bank liability insurance strongly favors the political approach over the economic approach as the potential economic efficiency gains of deposit insurance have been outweighed by its costs.

We argue that, consistent with political theories of deposit insurance, a major political advantage of deposit insurance is that it provides an effective means for government to supply hard-to-trace subsidies to particular classes of bank borrowers. Deposit insurance has not only protected banks and depositors, but the expansion of deposit insurance around the world has also offered a means of permitting banks to expand lending, which is often targeted to politically favored groups. In autocracies, insurance has been used to favor influential borrowers, which typically include industrial firms that participate in “crony” networks. Especially in democracies, insurance has been used to favor mortgage borrowers with political clout.

Section IV considers alternative government policies that protect bank liabilities under some circumstances (which we label “limited and conditional protection”). We contrast this limited and conditional protection with either unconditional liability insurance or with unconditional laissez faire policy. We show that, as a matter of theory, limited and conditional protection can be superior to either of the alternatives. We also show that, as a matter of history, limited and conditional protection is closer to the actual policies pursued prior to the spread of deposit insurance.

Section V concludes by summarizing our results and outlining remaining questions that should be addressed by political theories of the spread of deposit insurance.

Deposit Insurance

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