The Failure of Deposit Insurance and Government Bail out

Although bank deposits are short term debt contracts, banks lend the deposit funds as long term debts. To serve regular deposit withdrawal, banks allocate some percentages of the funds in forms of cash as a reserve. In normal situation, there is no problem with this method because the withdrawn funds will soon be replaced by other customers' deposits. 

However, bad lucks sometimes happen to some banks. If there are enough bad news, whether it's true or not, regarding to some bank that may affect its ability to repay all deposits, its customer start to line up withdrawing their money.  Certainly, the troubled bank can only serve the withrawal up to the amount of cash it has in the bank's vault. It may also borrow some money from other banks, usually at really high interest rate. The interest rate will becomes higher if other banks perceive the loan as risky, considering the possibility of the borrower bank closes its operation if the problem keeps worsening.

If the bank can no more borrow money from other banks, it turns to the lender of last resort: the central bank. The central bank loan usually come with high interest too, and or with several prudential requirements, including handover safe assets as collateral. 

Deposit Insurance and Government Bail Out

If even this step cannot save the banks, the troubled bank will be taken over by the deposit insurer. The deposit insurer will pay bank customers' deposits in exchange of the share of the  bank's ownership.  The deposit insurer will try to keep the bank running well, so that it can resell its share at price high enough to cover the insurer cost to pay customers' deposits. 

Most of the time, the resale price of the shares or the proceeds of bank liquidation if it should close its operaton, is not high enough and the insurer experience loses. In fact, the loses burden is shared among all banks.

The logic of the deposit insurance is just the same as a common car insurance, the intended beneficiary is the unlucky one, but it turns out that most beneficiaries are the careless ones. Regardless moral hazard incentives which any insurance create, it is unfair to let the careful individuals pay for the carelessness of others.

The problem of bank failures does not necessarily stop as a burden for deposit insurer which collects money from banks. The deposit insurer can handle the problem if there are only few small bank failures. But if there are many bank failures or one too big to fail bank, even deposit insurer can do nothing about it. At this level, government may be necessary to step in to save the troubled banks. 

Again, government often cannot recover all costs of bail out, thus it becomes taxpayers' burden. Now, it becomes much more unfair because most taxpayers have nothing to do with banking industry except as their customers, but they have to bear the burden. It is, however, often said that a collapse of banking industry will very possibly cause recession which advertently affect taxpayers. Because it is also taxpayers' concern to keep banking industry running, taxpayers should be willing to pay the cost for saving this industry.

Reckless Neighbor

Now, this kind of logic is similar to the case when you have reckless neighbor who often forget to turn the stove off  after cooking, and you are asked to pay the cost of fire safety equipment for your neighbor's house because you do not want the fire from their house spread to  your house. It is definitely unfair! Instead of you pay for their fire prevention cost, your neighbor have to choose either bearing that cost by themselves, or  paying for your loss if the fire happens to burn also your house. 

So, if it is unfair to let taxpayers bear the burden caused by bankers' fault, does it mean that we have to let economic crisis happens as credit crunch is taking place along with the bank failures? No, we don't. Indeed, we have to stop all those things happening since very beginning, at the very root of the problems, which is the vulnerability of our financial system.

As I described in the beginning of this post, our current financial system can only work under normal circumstances, when everything works. But this system is very sensitive to small disturbances. All measures currently applied to prevent this small shocks becoming larger, including deposit insurance and government bail out, costs a lot of resources paid by innocent people and inducing moral hazard.

Back to my analogy on reckless neighbor, telling them to install fire prevention system and pay it by themselves perhaps is still not enough. Neither can they be told to change their reckless behavior. What should be done is replacing their stove with automatic shut off stove.

Chicago Plan

My point is that we should transform our financial system to remove its vulnerability. I basically agree with the Chichago Plan of narrow banking. In this plan, bank is only a depository institution, not intermediary.   As merely depository institution, banks have to hold a hundred percent of deposits in form of cash reserves. Thus, they can always serve fund withdrawal and transfers any time without any risk of default.

Other institution can perform the intermediary function which always be more risky than depository function.  People who put money to intermediary institution should have been ready to accept the risk of losing their money, because they also seek the possibility of earning profit from their investment. This intermediary institutions should also protect firms from immediate liquidation of investment, thus a negative-expectation-driven rush of investor could not disturb the normal production process of companies. Thus, if some companies fail, or even some intermediary institutions fail, the panic investors of other intermediary insitutions cannot ruin the later which is still in a good condition.