Deposit insurance has been viewed by some as having made a major contribution to “increasing confidence, encouraging savings, promoting the growth of financial institutions and increasing the flexibility of monetary policy,” 1 while Friedman and Schwartz have claimed that “federal insurance of bank deposits was the most important structural change in the banking system to result from the 1933 panic, and, indeed in our view, the structural change most conducive to monetary policy since … immediately after the Civil War.” 2 In view of such claims, the increased popularity of deposit insurance schemes within the past two decades is not surprising. However, there are costs as well as-benefits associated with deposit insurance. It is possible that alternative approaches may be as effective as formalized deposit insurance schemes, 3 particularly in many of the developing countries where local circumstances may render deposit insurance inappropriate, or at least less effective. Indeed, Friedman and Schwartz have also pointed out that “to avoid misunderstanding, we should note explicitly that deposit insurance is but one of several ways in which a panic-proof banking system could have been achieved. Our comments are not intended to suggest that some other method might not have been preferable to deposit insurance.” 4
This paper briefly discusses the historical background of and the rationale for deposit insurance. It then discusses the costs attached to deposit insurance and some of the technical questions involved in designing an optimal deposit insurance system (e.g., should deposit insurance cover all deposits or should its coverage be limited), as well as the interrelationship between deposit insurance and other regulatory approaches. 5
Mr. McCarthy, an economist in the African Department, was an economist in the Central Banking Department when this paper was written. He is a graduate of the London School of Economics.
J. A. Marlin, “Bank Deposit Insurance—I: Its Development in the USA,” Bankers Magazine (London, September 1969), p. 117.
Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960, National Bureau of Economic Research (Princeton University Press, 1963), p. 434.
For example, either credit insurance or more stringent regulations (including, perhaps, increased capital requirements) could theoretically serve as substitutes for deposit insurance.
Friedman and Schwartz (cited in n. 2), p. 442, n. 18.
Argentina, Canada, Chile, the Federal Republic of Germany, India, Japan, Lebanon, the Netherlands, the Philippines, Turkey, the United Kingdom, and the United States have introduced deposit insurance schemes: Marlin (cited in n. 1), p. 116. The Netherlands is about to establish a broader scheme than the present one (which covers only the cooperative banks), and the United Kingdom has replaced an ad hoc rescue operation (the “lifeboat”) with a formal insurance scheme. This study draws upon a more detailed survey, copies of which may be obtained from the author, whose address is International Monetary Fund, African Department, Washington, D. C. 20431.
For example, Indiana’s scheme operated successfully from 1834 to 1865, until the taxation of circulating notes of banks caused its closure: Federal Deposit Insurance Corporation, “History of Legislation for the Guaranty of Bank Deposits,” Annual Report, 1950, Part III, p. 64.
Ibid., p. 65.
American Bankers Association, Economic Policy Commission, The Guaranty of Bank Deposits (New York, 1933), p. 42.
Federal Deposit Insurance Corporation (cited in n. 6), p. 68.
Quoted by L. J. H. Dark in A. M. Allen, S. R. Cope, L. J. H. Dark, and H. J. Witheridge, Commercial Banking Legislation and Control (London, 1938), p. 137.
In practice, the contributions tended to be ex post rather than ex ante and were paid directly to depositors.
The original plan for the FDIC also included a scheme for partial reimbursement of all deposits, as opposed to the final scheme which provided full reimbursement of part of deposits.
Robert E. Barnett, “FDIC: Six Alternatives to the Present Deposit Insurance System,” address before the Nebraska Correspondent Bank Conference, Lincoln, Nebraska, September 24, 1976, FDIC News Release PR-82-76 (September 24, 1976), p. 1.
Federal Deposit Insurance Corporation, Annual Report (various issues).
Many of the failing banks were not eligible for refinancing because they were not members of the Federal Reserve System.
W. E. Gibson, “Deposit Insurance in the United States: Evaluation and Reform,” Journal of Financial and Quantitative Analysis, Vol. 7 (March 1972), pp. 1575-94; Kenneth E. Scott and Thomas Mayer, “Risk and Regulation in Banking: Some Proposals for Federal Deposit Insurance Reform,” Stanford Law Review, Vol. 23 (May 1971), pp. 857-902.
Talal Georges, Le Système Monétaire et la banque au Liban (Beirut, 1970), pp. 171-85; Harold S. Taylor, “The Day They Shorted the Intra Bank,” Bankers Magazine, Vol. 150 (Boston, Winter 1969), pp. 9-18.
A. Dale Tussing, “The Case for Bank Failure,” Journal of Law and Economics, Vol. 10 (October 1967), pp. 129-48, and “Meaningful Bank Failure: A Proposal,” Journal of Industrial Economics, Vol. 18 (July 1970), pp. 243-55.
A. Dale Tussing has made the strongest arguments for this approach: ibid.
U.S. Representative Wright Patman, then Chairman of the House Banking Committee, was quoted as saying that when we boast of no bank failures, let’s remember that several thousand other business firms may have failed because the banks did not take as many reasonable risks as they might have taken.”—George J. Benston, “Bank Examination,” The Bulletin, Nos. 89-90, New York University, Graduate School of Business Administration, Institute of Finance (May 1973), p. 63.
The Chairman of the FDIC was quoted as saying that “one-hundred percent deposit insurance would probably improve the competitive positions of small vs. large banks and of new vs. established institutions.”—Barnett (cited in n. 13), p. 6.
Abstracting as well from the perennial second-best problem.
Tussing, 1970 (cited in n. 18), p. 245.
Robert C. Merton, “An Analytic Derivation of the Cost of Deposit Insurance and Loan Guarantees: An Application of Modern Option Pricing Theory,” Journal of Banking and Finance, Vol. 1 (June 1977), pp. 185-206.
Since the ratio of deposits to total assets is effectively equivalent to 1 minus the ratio between capital and reserves and total assets.
Y. E. Orgler, “Capital Adequacy and Recoveries from Failed Banks,” Journal of Finance, Vol. 30 (December 1975), pp. 1366-75.
Scott and Mayer (cited in n. 16), p. 858.
Scott and Mayer (cited in n. 16), p. 858.
Jack Revell, “Reforming UK Bank Supervision,” The Banker, Vol. 126 (September 1976), pp. 1021-24; Thomas Mayer, “A Graduated Deposit Insurance Plan,” Review of Economics and Statistics, Vol. 47 (February 1965), pp. 114-16; Scott and Mayer (cited in n. 16); Robert Taggart, Jr., “Regulatory Influences on Bank Capital,” New England Economic Review, Federal Reserve Bank of Boston (September/October 1977), pp. 37-46.
Barnett (cited in n. 13), pp. 16-18.
In the Credit Cooperatives Security Scheme.
Although membership is theoretically voluntary in the United States, nationally chartered banks and members of the Federal Reserve System are required to join.
Revell (cited in n. 29); David Burras Humphrey, “100% Deposit Insurance: What Would It Cost?” Journal of Bank Research, Vol. 7 (Autumn 1976), pp. 192-98; Gary Leff, “Should Federal Deposit Insurance be 100 Percent?” Bankers Magazine, Vol. 159 (Boston, Summer 1976), pp. 23-30.
Thomas Mayer, “Should Large Banks be Allowed to Fail?” Journal of Financial and Quantitative Analysis, Papers and Proceedings, Vol. 10 (November 1975), pp. 603-10; Barnett (cited in n. 13).
A procedure whereby the FDIC assumes the bad debts of a failing bank and sells the remainder of the operation as a going concern to another bank.
Barnett (cited in n. 13), p. 2.
Humphrey (cited in n. 33).
Sam Peltzman, “Capital Investment in Commercial Banking and Its Relationship to Portfolio Regulation.” Journal of Political Economy, Vol. 78 (January-February 1970), pp. 1-26; J. J. Mingo, “Regulatory Influence on Bank Capital Investment,” Journal of Finance, Vol. 30 (September 1975), pp. 1111–21. Peltzman finds a clear substitution, while Mingo’s results are ambiguous. However, to the extent that deposit insurance decreases the risk of failure resulting from runs on otherwise solvent banks, it can be argued that a decrease in capital (and liquidity) ratios concurrent with the introduction of deposit insurance represents a rational response to decreased risk rather than a substitution.