Which Depositors Should Suffer Losses When a Bank Fails?

Because they are simply fixed-income investments with a different name, in a reformed world, 70% of deposits might rank pari passu with senior bonds when it comes to sharing losses. Obviously, this makes them junior to transactions accounts and savings accounts, and also junior (instead of senior, as they now are) to taxpayers.

Such a bail-in would substantially reduce the perverse incentives and moral hazard of government deposit insurance, while arguably being more true to its original purpose. Buyers of these investments would care a lot more about the credit standing and capital of the bank and need appropriate disclosures, just like buyers of other investments sold to the public. Deposit insurance would have to be restructured.  Banking leverage would fall and capital ratios would rise. People would work on how to game the system, of course, but moral hazard in banking would be much reduced.

Whatever one may think about the details, we should reject the current article of faith and instead consider which depositors should be bailed in along with bondholders.

Alex J. Pollock is a resident fellow at the American Enterprise Institute in Washington. He was a president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.