This post is based on discussions with George Selgin and correspondence with William Melick. Melick sent a copy of a paper he wrote with Randall Kroszner, called “Lessons from the U.S. Experience with Deposit Insurance,” in which they write,

the latest historical evidence accumulated from painstaking examinations of bank failures and panics suggests that contagion from unhealthy to healthy banks usually was not present during bank panics and failures. Rather, this evidence suggests that panics were usually associated with depositors moving from unhealthy banks (and banks associated with unhealthy banks) to healthy banks, what we term a separating equilibrium. Indiscriminate runs on all banks, what we term a pooling equilibrium, were relatively rare and in one instance triggered by official recourse to statewide bank holidays. This distinction between a separation and a pooling equilibrium provides a new prism through which to view the function of deposit insurance. If failures and panics are best viewed as separation equilibria, then using deposit insurance to protect the medium of exchange may preserve and encourage the expansion of unhealthy banks, potentially generating undesirable credit expansions that in the end prove quite costly.

This paper appeared as a chapter in this volume.

The standard view is that banking in a free market is inherently fragile, which makes deposit insurance necessary. In fact, some would argue that the concept of insurance needs to be extended to the so-called “shadow banking system.” I think of Perry Mehrling and Gary Gorton as being in that camp.

The revisionist view is that deposit insurance is a case of the government concocting a solution to a problem that was created by government in the first place. That is, the U.S. banking system was unstable due to regulations that promoted small, local banks and inhibited the creation of diversified nationwide banks. Had banks been allowed to branch across state lines or had national bank holding companies been allowed to grow naturally, then (according to this argument) we would have seen few bank failures, even in the 1930’s. Hence, there would be no need for deposit insurance.

Instead, we created deposit insurance. That in turn led other countries to adopt deposit insurance, even though their banks were not as fragmented and risky as ours.

The net result of this spread of deposit insurance was to de-stabilize the banking system. That is because it created moral hazard, which regulators were not willing/able to offset.

I am not saying that I am on board with this revisionist analysis. But it is a provocative suggestion.