I'm confused. And the more speeches I read by government policymakers on why we can't or shouldn't reform the deposit insurance system, the more confused I get.
Deposit insurance was first adopted by New York State in the 1820s. During the next century more than 150 proposals for federal deposit insurance were introduced.
The proposals were rejected despite periodic market crashes, economic depressions, and banking panics. They were rejected even though hundreds of banks failed annually, even in some very prosperous times such as the 1920s.
The Crash of 1929, followed by the Great Depression and the banking collapse, resulted in still more proposals for federal deposit insurance. President Roosevelt and the American Bankers Association opposed this solution to banking's problems.
They believed deposit insurance would force strong banks to subsidize marginal banks, undermining discipline and creating a huge moral hazard. They believed it would be better to allow the marketplace to work by authorizing nationwide branching. Strong banks would acquire weaker banks and diversify geographically.
Regrettably, the proponents of market-based solutions to the banking crisis lost the argument. The banking industry wasn't allowed to restructure itself, and instead, a limited depositor protection plan ($2,500 per depositor) was adopted.
The depositor protection plan was accompanied by a host of restrictions on competition. Deposit interest ceilings were imposed, entry into the banking business was tightly controlled, and the range of activities permitted to banks was restricted.
The combination of a modest insurance limit and tight restrictions on competition served to keep the moral hazard to a minimum. Moreover, bankers were so risk-averse after the Great Depression that limitations on their activities weren't really needed.
The restraints on competition began breaking down in the 1970s, and there's not much left of them today. The deposit insurance system, on the other hand, has grown much more pervasive.
The insurance limit has been increased to $100,000, and that's just the tip of the iceberg. A family of four can obtain more than $1 million of coverage in a bank by arranging their accounts in certain ways. Money brokers can place billions of fully insured dollars in a single bank. Moreover, for banks considered too big to fail, the nominal insurance limit is meaningless because all depositors are routinely protected.
The moral hazard so feared by President Roosevelt is present to a degree he could not have imagined. The $150 billion charged to taxpayers in the S&L crisis illustrates vividly just how costly the moral hazard can be. The solution seems pretty obvious.
Banks need to be freed from the remaining government restraints on competition. If they are not, their position in the marketplace will continue its steady erosion.
If the restraints are eliminated, the marketplace should be allowed to discipline banks that take excessive risks. For this to happen, the deposit insurance system must be reformed to reduce the protection afforded depositors and other bank creditors.
Unfortunately, public policy is taking us in a different direction. The government failed miserably in anticipating and preventing problems in the S&L industry. Then it responded to the crisis with a plethora of new laws and regulations that make it even more difficult for banks to be cost- effective competitors.
Why settle for less than the real thing? Why keep a pervasive safety net that requires the government to try to replicate marketplace discipline? Why not take the less costly and more effective route of reducing the safety net so the marketplace can work its magic directly?
