This article was first published by Business Day on 16 May 2023
On the dangers of bank deposit insurance
Bank deposit insurance exacerbates the very crises it is assumed to alleviate. It inevitably promotes its own expansion and perforce brings calls for yet heavier regulation.
With the launch of the new Corporation for Deposit Insurance (CODI), bank customers and other taxpayers have the honour of supporting another government agency and an expanded crew of civil servants. In return for that expense, bank customers now have the assurance of specified levels of compensation in the unlikely event that their bank fails to meet its obligations. But as is true of all forms of social insurance, the real cost burden on society will be higher than expected, and it will not function as true insurance.
This is not news, nor is it ideological speculation. Knowledge of prudent banking practices has developed over many centuries. Any business professional involved in risk management knows something about the concepts of moral hazard and adverse selection. Government officials should understand these matters also, for it affects their operations both internally and in the outward consequences of their policies.
CODI has started out conservatively by promising to insure only R100 000 of deposits per account. Now bank customers can relax in the soothing knowledge that portions of their savings are safe no matter in which bank they deposit them. They may not even notice the small percentage fee that is taken and added to the insurance pool. We seem to have gotten something for almost nothing – and if we focus only on that little piece of the story, we can be happy.
For a large majority of bank depositors, the riskiness of their bank is no longer an issue of concern, and they have little incentive to seek information comparing each bank’s quality with the others. Bank managers now have even less reason to treat the safety of deposits as a competitive advantage. Perceiving a reduced risk of deposit volatility, and an even smaller risk of a bank run, they will compete on other aspects of customer service and convenience. Prudent risk management is now of less concern to managers. Their customers will not notice when they sacrifice a bit of their safety to enhance bank profits. We call that “moral hazard”.
A properly functioning insurance plan would pool banks according to their risk levels and set the premiums to be paid accordingly. Banks in a lower risk class would pay lower premiums, thereby rewarding less-risky or more prudent behavior. But CODI will charge premiums based on a set percentage of deposits held by each bank, not by the riskiness of each bank. By failing to price the insurance correctly, CODI will compound the risk of adverse selection with the problem of moral hazard described above. Those banks that are operated prudently will overpay and those that are managed in a riskier manner will pay less than they should for insurance. Given these compounding perverse incentives, we should not then be surprised by the future emergence of more risky banks. Neither should a restauranteur that charges a fixed price for an “all-you-can-eat” dinner be surprised that his customers include more rugby players than ballerinas.
As with any insurance customer, bankers who are less concerned with the risk of deposit volatility, meaning the risk of customers withdrawing their deposits, may be more inclined to take on greater but more profitable risks in their asset-liability mix. Such effects of moral hazard are magnified to the extent that banks reward executives with bonuses when their greater risk-taking is more profitable but expect to be bailed out when their risks go bad.
Not all banks are equal in their cultures and attitudes toward risk. In an environment where some risks are mispriced and some are misperceived, prudent bankers could come under pressure to emulate their ostensibly more-profitable competitors. In periods of prosperity, such unsustainably profitable behaviors will tend to grow and, especially among new or smaller competing banks, come to be perceived as normal. In this sense, good times can breed weakness. And weakness sets us up for even worse failures in the future, calling for yet more regulation.
Over the centuries, bankers and other market participants who have survived the vagaries of the marketplace and of various political regimes were those who developed or learned methods for the detection and avoidance of bad risks. As the political regimes and institutional structures change, the cultures of banks and other businesses will also adapt to these changes. Indeed, it is in the interests of these businesses reflexively to seek influence over those same political and institutional structures. And although each new government program or proposed agency is introduced with a happy narrative of the expected net benefits for “the people,” the conduct and missions of such agencies tend to evolve under political pressures, and the threat of regulatory capture is ever present.
Deposit insurance covers the risk in one part of our lives, while opening us up to other risks and increasing financial burdens. If American experience is a worthy indicator, in the next crisis, R100 000 will prove not to be enough. Political pressures, and fears of contagion, will likely press coverage levels higher with each episode. And to the extent that deposit insurance contributes to the very crises that it was intended to alleviate, it will promote its own expansion and bring calls for even heavier regulation.
As each new government agency arrives to protect us from the risks of life, and each becomes more tightly entwined in our businesses and livelihoods, we will discover that getting something for nothing can be very expensive.