A new approach to deposit insurance

Joint post with Euronomist.

Recent developments in the Eurozone, specifically Cyprus where the first EU-dictated bail-in of bank depositors took place, brought to light an important issue which had been hiding in the shadows: the flawed nature of current deposit insurance schemes.

Some advocate abolition of deposit insurance because it distorts incentives for banks and savers. But others believe that it is necessary to avert panic every time a bank nears its inevitable death. Yet although the two ends of the spectrum appear to disagree on the specifics of their proposals they both agree that the deposit insurance scheme needs to change if we want the future of both the financial sector and the wider economy be brighter than the present. In this article we present and develop a scheme which will address the need of depositors for safety without creating distorted incentives, while simultaneously helping to ensure the viability and stability of the banking sector in time of crisis.

A flawed scheme

The main purpose of the deposit insurance scheme is to safeguard depositors in the event of a financial institution’s bankruptcy. In addition, by guaranteeing the funds in a person’s account it prevents panic from spreading in the economy, with horrified citizens rushing to their banks so that they can withdraw their hard-earned money. Nevertheless, it has disadvantages. When banks do not have to fear for their customers’ funds they may indulge in risky speculative deals which destabilize both the bank itself and the economy in general. This is not pure speculation: in one of the first deposit insurance schemes, bank failures actually increased due to increased liquidity and terrible choice of investments (notably real estate).

While the success of the deposit insurance scheme mainly depends on the good reputation and financial strength of the state backing it, bank failures can be costly to the economy. The cost to the state of large bank insolvency can be billions of currency. This amount has to be generated either by increasing taxation or by additional Government borrowing, which in turn will require increased taxation or reduced government spending which, depending on the state of the economy, may result in a severe recession. Governments that have currency-issuing capability may alternatively opt for printing money, which means that the taxpayer will essentially be paying for the bank’s failure through reduction of real buying power. In the financial crisis of 2008, taxpayers paid for the mistakes of bankers. The direction of discussion ever since has been around how to limit the consequences of bank failure for taxpayers by forcing bank creditors to bear more of the cost. The bail-in of Cyprus depositors and the haircut suffered by depositors in the UK’s Southsea Bank failure were such attempts, but the price that may be paid for this is greater likelihood of damaging large deposit bank runs and/or disintermediation of the banking system, introducing even more funding fragility for banks and increasing their reliance on the central bank.

Yet abolishing deposit insurance could have terrible consequences. In the event of a major bank failure, with thousands of people losing their money, a mass bank run with disastrous effects on liquidity and asset prices would be likely. In the absence of deposit insurance a single bank failure may escalate into a systemic crisis, followed by a major recession with money becoming a scarce resource. This has already happened before, in 1930, when, in the US, 744 banks failed in the first 10 months of the year, with more than 9,000 failures in the subsequent decade. Even though we have progressed in many respects since the 1930’s, convincing someone that his or her money is safe in the bank when a friend of theirs has lost everything in a bank failure would be difficult. Anyway, the depositor may be right: the repercussions of one bank’s failure may cause another to go bankrupt even if no withdrawal of funds is made.

Although the deposit insurance scheme bears the name “insurance”, it does not resemble normal insurance policies. When someone wants to insure a house or an automobile an amount of money – the premium – has to be paid in advance in order for the insurance company to assume the risk of compensating the owner if something goes wrong. This, however, is not the case with deposit insurance: the depositor does not have to pay any amount of money as a premium for having the deposited funds insured by the state. Instead, in European countries, the state imposes a levy on banks to cover the cost of anticipated deposit insurance claims. Bank depositors unwittingly pay for this through lower interest rates on their savings: but the burden is also shared by borrowers through higher interest rates, employees through lower wages and shareholders through smaller dividends. And in a systemic crisis, the insurance fund is never enough anyway. The UK’s FSCS was topped-up by state funding in 2008 and has had to repay that through additional levies on the financial institutions that did not fail – hardly an encouragement of sound financial management.

Nor is the state necessarily obliged to honour deposit insurance. Iceland refused to honour deposit insurance for foreign depositors in its banks. The UK and the Netherlands challenged this in the EFTA court and lost their case. At present, no European sovereign is obliged to honour deposit insurance in a systemic banking failure. Fortunately for the stability of the European banking system, this is not widely known: but the first Cyprus bail-in proposal, which would have partially bailed-in small depositors who were supposedly protected by deposit insurance, depended on it.

A new proposal

Our proposal is that depositors should explicitly pay a premium for the benefit of having the money insured. We limit this to interest-bearing accounts, because we consider non-interest-bearing (transaction) accounts to be a social good which should be protected by government without further cost to citizens. We propose therefore that transaction accounts would continue to be insured without explicit charge, but would no longer bear interest: insurance for transaction accounts would continue to be paid by bank levy.

Some might believe that insurance for interest-bearing accounts could be entirely provided by the private sector. But recent events suggest otherwise: when AIG became the largest underwriter for sub-prime mortgage CDS’s, nobody thought it would face trouble; the company was (and still is) one of the biggest insurers in the world. Yet, when the whole charade collapsed in 2008, AIG would have gone down with it if the US government had not bailed it out. Even insurance agencies which focus on extreme catastrophes like hurricanes, earthquakes, etc. would have trouble repaying the billions needed when it came to a systemic bank failure. In addition, private insurers would have an incentive to keep that money employed in projects so it could receive a high rate of return to make up for the costs of running the business: this runs the risk that in the event of a major bank failure the funds would be tied up in other investments with no immediate means of realising them, which would bring the insurer down with the bank and force the state either to repay the insured depositors itself or let them take the fall. Neither of these options is a good one, and we would thus prefer the state to assume the role of the insurer itself.

When we talk about the state, we usually mean government. But in this case we think the role of the insurer should fall to the Central Bank. There are two reasons for this:

The Central bank is (theoretically) independent of political agendas and has more access to classified banking data than any other agency. This would allow the Central Bank to perform a better analysis of the probability of an institution failing, thus making the insurance premiums commensurate with the realities of the banking industry.
The ability of the Central Bank to create unlimited liquidity would enable depositors to access their money in a systemic crisis without causing fire sales of assets and price crashes setting off a rapid deflationary spiral as happened in 2008.

Since in many countries the Central Bank is also responsible for prudential regulation of the banking industry, care would be needed to ensure clear separation of function to avoid conflict of interest. This would be best achieved by maintaining the insurance fund as a separate legal entity with its own management under the Central Bank umbrella.

Transparency would also be important. The fund’s management should be obliged to make public every quarter the size of the fund, the amount of deposits it insures and provide an annual report signifying the events of the past year. In addition, the fund’s financial statements should be audited by independent auditors.

As this fund would be literally a pool of money, the following questions arise:

How should this money be invested so that it remains safe and is available when required?
What should happen if the accumulated amount of insurance premium became disproportionately large in relation to the value of deposits to be covered?

Regarding the first question, it would be extremely unwise for deposit insurance funds to be placed with the banks whose deposits it was intended to insure, or with other institutions that depend on those banks. Therefore it would probably be sensible for the fund to be restricted to investments in safe assets such as high-quality government debt. Central banks already have lists of acceptable collateral for funding and these would be a good start point for acceptable investments for the insurance fund, although the insurance fund’s list might need to be more restricted. In any event, there should be an explicit commitment from the Central Bank to top up the insurance fund should it suffer losses due to asset failure, including the failure of its own government’s debt. For Eurozone countries whose central banks are unable to create money, it might be wise to use the ESM to top up deposit insurance funds, with the ECB standing as insurer-of-last-resort in the event of the ESM being unable to cover the losses. Ensuring the safety of insured depositors and the stability of the banking system is more important than political arguments over whether or not this would constitute monetization of state debt.

Regarding the second question, it is of course necessary for an insurance fund to have a safety margin in excess of expected claims. This would be invested in safe assets in the same way as the rest of the fund. However, if the excess became too great it could be returned to depositors either as a reduction in future premium payments or as a tax credit. The premium is, after all, effectively an hypothecated tax on savings.

We are now reaching the most important part of the analysis: who should receive deposit insurance, how much that insurance should cost and what the insurance limits should be. The key points are:

Transaction accounts would be fully insured for no charge, but would no longer bear interest.
All interest-bearing deposit accounts would be subject to an insurance premium which would take the form of a marginal reduction in the interest rate.
On interest-bearing accounts, customers will have the option of refusing deposit insurance, in which case they will receive a higher rate of interest but will not be protected in the event of bank failure.
There would be no insurance limit on interest-bearing accounts. However, we would recommend a tiered insurance premium structure: deposit insurance premiums should be higher for larger amounts and higher interest rates, to reflect the increased risk they represent and discourage routine placing of large sums in insured deposit accounts as an alternative to other safe assets.
There would also be no insurance limit on non-interest-bearing transaction accounts. However, there would be a time limit on the account, beyond which funds in excess of a certain amount (possibly the current deposit insurance limit) would be automatically swept into an interest-bearing account.

To ensure transparency and avoid mis-selling, account opening procedures will need to be amended. On account opening, the bank should offer the depositor three options:

A non-insured account with an interest rate of X
An insured account with an interest rate of say (1-0.075)*X
An account without an interest rate (transaction account)

The costs, benefits and risks of all three should be clearly explained. Additionally, it should not be possible to open a non-interest-bearing transaction account without also opening an interest-bearing account, either insured or uninsured.

Under the present deposit insurance scheme, the amounts insured are limited. There may be a view that insurance limits should continue under this scheme too. But we think the risk of destabilising runs on large deposits is sufficiently great for this not to be a wise decision. The imposition of capital controls in Cyprus to prevent large deposit runs has been economically damaging and we think it would be better to remove the incentive for large deposits to run. We suggest therefore that there should be no limit to the funds that can be insured in interest-bearing deposit accounts, but that higher insurance premiums should be charged for larger deposits to encourage investors to place funds elsewhere. Unlimited insurance on interest-bearing deposit accounts (for a price) would still give large investors an alternative to government debt as a safe asset, which in a market panic could help to ensure the stability of the banking system.

In the case of accounts with no interest rates (principally transaction accounts) we also propose that the amount insured should be unlimited. This is because the current EUR100,000 limit in the European deposit guarantee scheme is far too low for many corporate and some individual depositors. Corporate payrolls, for example, can be far in excess of the EUR100,000 limit and are in no sense “savings” – they are people’s wages. People buying and selling houses may also have funds far in excess of the limit going through transaction accounts, and would face homelessness if these funds were lost due to a bank failure while they were in transit. The US’s FDIC limit is $250,000, but even this is insufficient for some depositors. Loss of funds “in transit” can have terrible social and economic consequences, and we think therefore that deposit insurance should cover them regardless of the amount. We therefore propose, instead of an insurance limit, a time limit for funds in excess of the current deposit insurance limits. Funds in excess of this amount may remain in an insured non-interest-bearing account for e.g. 60 days, after which they would automatically be “swept” into an interest-bearing demand deposit account and insurance would be charged unless the depositor has opted out of insurance on that account.

Concern has been expressed that unlimited insurance would lead to abuse of transaction accounts by large investors seeking safety. However, we think this concern is unfounded. Under normal circumstances, a large investor would prefer interest-bearing safe assets over a non-interest-bearing insured account. Only under exceptional circumstances – say a debt crisis where safe assets were no longer “safe” – would an investor forego interest for safety. And under these exceptional circumstances, it would be sensible to allow them to do this in order to head off destabilising runs and ensure the stability of the financial system.

In conclusion….

We would like to remind the reader that the current state of the deposit insurance scheme is far from ideal. We have proposed an alternative which we believe would protect depositors from losses and prevent destabilizing bank runs without causing moral hazard for banks and the prospect of unsupportable losses for the state.

A new approach to deposit insurance

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