Deposit insurance without commitment: Wall Street vs. Main Street

Russell Cooper, Hubert Kempf

18 February 2011

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The events which followed the subprime crisis, which started in August 2007, were shocking news to many economists. Bank runs were back!

  • In September 2007, a British bank, Northern Rock, experienced a run (see Shin 2009 for a detailed account). The British government had to come to the rescue and subsequently nationalised a large fraction of the British banking sector. During the crisis, it uplifted its deposit insurance scheme and eventually modified the entire system of financial supervision (UK Treasury 2008).1
  • A year later, on 15 September 2008, Lehman Brothers, an ailing investment bank, filed for bankruptcy protection following the massive exodus of most of its clients, drastic losses in its stock, and devaluation of its assets by credit rating agencies.
  • Following this and the 10-day run on Washington Mutual, which ended by its failure on 26 September 2008, the Federal Deposit Insurance Company raised the insurance upper limit on bank deposits to $250,000.
  • This lift was made permanent in 2010 by the Dodd-Frank Wall Street Reform and Consumer Protection Act.
  • In late September 2008, the Irish government guaranteed the €400 billion (£315 billion) of savings and loans held by six of its largest financial institutions in what bankers said was a de facto nationalisation of the industry.

These were shocking events because it was taken for granted that bank runs were things of the past.

Analytically, following the seminal paper by Diamond and Dybvig (1983), it was thought that the implications of deposit insurance were well understood. If agents believed that deposit insurance will be provided, then bank runs – which were driven by beliefs, after all – would not occur. In equilibrium, the government would not need to act. Deposit insurance would never need to be provided and costly liquidations would not occur. Instead, deposit insurance works through its effects on beliefs, supported by the commitment of a government to its provision.

The law of unintended consequences

But these bank runs and the modifications of the parameters of deposit insurance schemes lead us to question the credibility of the government’s commitment. More troubling, in some countries, the fate of deposit insurance is to be questioned. In China, for example, the exact nature of deposit insurance is not explicit. And, in Europe, the combination of a common currency, the commitment of the ECB not to bailout member governments, and fiscal restrictions casts some doubt upon the ability of individual countries to finance deposit insurance as needed.

Finally, in all of these instances, there is also the question of how broadly to define a bank and thus the types of financial institutions to be covered by some form of public insurance. The bailout of AIG, for example, along with the choice not to bailout Lehman Brothers, makes clear that some form of deposit insurance is possible ex post for some, but not all, financial intermediaries (see Bernanke 2010).

It is these examples of ambiguity in the provision and extent of deposit insurance that motivates our study deposit insurance without commitment (Cooper and Kempf 2011). We seek to identify conditions under which this insurance will be provided.

Our research

There are two central building blocks for our analysis.

  • First there is the standard argument about gains to deposit insurance, as in Diamond and Dybvig. These gains are present in the ex post choice of providing deposit insurance since agents face the prospect of obtaining a zero return on deposits in the event of a run.
  • Second, there are potential costs of redistribution across heterogeneous households. This depends on the social objective function. These costs of redistribution play a key role in a previous study of ours with Dan Peled (Cooper et al. 2008) of bailout of one region by others in a fiscal federation. That analysis highlights two motives for a bailout, i.e. the smoothing of consumption and the smoothing of distortionary taxes across regions. Here, instead of regions, we consider an economy with heterogeneous households. The redistribution arises both from the distribution of deposits across heterogeneous households and the tax obligations needed to finance deposit insurance.

As long as the insurance gains dominate, deposit insurance will be provided ex post and there is no commitment problem. But, if the deposit insurance entails a redistribution from relatively poor households to richer households and the social welfare function places sufficient weight on poor households, then deposit insurance will not be provided.

The redistributive effects of different forms of bailouts are surely present in the ongoing political debate, summarised as "Wall Street vs. Main Street". The contribution of our research is to analytically focus on these effects and provide a framework to address the dilemmas faced by policymakers when bank runs are under way or are about to start.

Policy issues

Three dimensions of this issue are explicitly addressed in the paper.

  • First, the properties of the tax instruments to be used in the case of providing deposit insurance play a central role in shaping the trade-off.

If the policymaker has full flexibility over taxes, then it will always be able to shape the tax profile in such a way that deposit insurance will be provided. However, if it must use a predefined tax schedule, then this conclusion does not hold.

  • Second, the extent of a run, that is the number of banks subject to a run, matters.

If all banks experience a run, the run is “systemic”; if only a subset of banks is exposed, the run is “partial”. The distinction is important. In the case of a partial run, depositors in “safe” banks may be taxed in order to support the deposit insurance scheme put in place for depositors in “failed” banks. Thus, this opens another dimension of transfers, between customers of differently exposed banks.

  • Third, the issue of the power to liquidate a bank subject to a run is crucial.

If the bank retains the power to liquidate long-term investment in order to respond to a run, this has two consequences:

  • Early liquidation generates some inefficiency due to liquidation costs.
  • The provision of deposit insurance does not prevent runs.

If we think of deposit insurance as a redistributive scheme among agents claiming to be early consumers, then those claiming to be late consumers will have nothing to consume given the liquidation.

Thus it is in their interest to misrepresent and claim to be early consumers as well. The bank run is not eliminated. However, if the government is given control over the liquidation decision and the consumption allocations of early and late consumers as soon as a bank realises that a run is underway and prior to liquidation, then the possibility of a run is eliminated as truth-telling by patient depositors is a dominant strategy.

The issue of no commitment with respect to deposit insurance should now be related to the relation of the “too big to fail” problem. In that setting, there is a fundamental heterogeneity across banks. Some are more essential to the financial system than others. It will be of interest to allow for those asymmetries across financial institutions and understand the trade-off between insurance gains and redistribution costs in that environment.

References

Bernanke, Ben S (2010), “Implications of the financial crisis for economics”, Speech at the conference co-sponsored by the Center for Economic Policy Studies and the Bendheim Center for Finance, Princeton University, 24 September.

Cooper, R., H. Kempf (2011), “Deposit Insurance Without Commitment: Wall St. Versus Main St”, NBER Working Paper No. 16752.

Cooper, R, H Kempf and D Peled (2008), “Is it is or it is ain't my obligation? Regional Debt in a Fiscal Federation”, International Economic Review, 49:1469-1504.

Diamond D and P Dybvig (1983), “Bank Runs, Deposit Insurance and Liquidity”, Journal of Political Economy, 91:401-419.

Shin, HS (2009), “Reflections on Northern Rock: the bank run that heralded the global financial crisis”, Journal of Economic Perspectives, 23:101-119.

UK Teasury (2008), Treasury – Fifth Report, Treasury Committee to the House of Commons, 24 January.


1 See the UK Treasury (2008), including “The run on the Rock” and section 6 “Depositor protection”.

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Topics:  Financial markets Global crisis International finance

Tags:  moral hazard, financial regulation, bank runs

Russell Cooper

Professor of Economics, European University Institute

Hubert Kempf

Professor of Economics, Université Paris-1 Panthéon-Sorbonne and Paris School of Economics

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