By Arnold Kling
What is the state of the art in understanding deposit insurance? I am interested in survey articles that cover thinking in the last twenty years or so.
Suppose we start with a distinction between a solvency problem and a liquidity problem. If the bank is insolvent, it has negative net worth. If it is illiquid, it has positive net worth but if faced with a run would have to sell assets at prices below their true value, so it cannot meet depositor needs.
1. I suspect that the case for using deposit insurance to protect banks that are illiquid is better than the case for using deposit insurance to protect depositors against insolvency. Protecting depositors against insolvency can work out to be a pure transfer from taxpayers to bank owners, assuming that bank owners figure out how to maximize the value of their put option–that is, the option to put the bank back to the insurance agency.
2. I suspect that it is hard to structure deposit insurance so that it protects against illiquidity without protecting against insolvency.
3. I suspect that there are contractual arrangements that address the problem of illiquidity that are better than deposit insurance. That is, there are arrangements that take away the incentive to participate in a bank run while not giving the bank owners a put option with respect to the insurance agency.
4. One obvious contractual arrangement would be a money market mutual fund in which “breaking the buck” is not viewed as something unthinkable. Gosh, if we were typically running inflation of 1 percent a month, then a money market mutual fund that had a yield of less than 1 percent a month would be doing the same thing as a money market fund that broke the buck in a zero-inflation environment, no?
I am thinking about this in the context of government financial guarantees in general. It strikes me that deposit insurance is the government guarantee with the strongest case. If that case is weak, then the case for other guarantees is likely to be weaker.